One of the most popular strategies related to implicit subsidies is the FX carry trade. On its own, it is not a very precise and reliable estimate of expected returns but only a starting point for good systematic strategies. However, at times (particularly in the 2000s) positions in floating and convertible currencies with significant real interest rate differential to the USD have benefited from two types of implicit subsidies.
- First, central banks often impose high real local short-term interest rates and engage in FX interventions, in both directions, to reduce inflation and financial uncertainty. Such policies benefit the risk-return trade-off of agents that lend in local currency and fund in foreign currency. Empirical research shows that official currency interventions can cause persistent external imbalances and over- or under-valuation of a currency (view post here). Moreover, central banks that lean against the wind of carry flows through sterilized currency interventions create what is called an “FX forward bias”, a combination of interest differential and expected currency appreciation (view post here). Suppressed valuation and forward bias offer implicit subsidies to the market as a whole.
- Second, corporates, banks and households that are fearful of financial turmoil often prefer holding ‘hard currencies’ or ‘funding currencies’ rather than ‘carry currencies’ in order to contain downside risk for business or to preserve subsistence. For example, non-U.S. financial institutions hold precautionary positions in U.S. dollar assets as protection against funding pressure (view post here). Also, in EM economies companies often buy dollars in crisis periods to secure liquidity for international transactions. Forgoing expected returns in such situations is similar to paying insurance premia. Indeed, FX carry trades have historically been most profitable when fear of disaster caused both high interest rates and undervaluation (view post here). Likewise, there is evidence that high risk aversion as measured by volatility risk premia, differences between options-implied and actual volatility, leads to undershooting and subsequent outperformance of carry currencies (view post here).
FX carry opportunities depend on market structure and regulation. In emerging markets observed carry typically contains a combination of classic interest rate differential and an arbitrage premium that reflects the state of on-shore and off-shore markets (view post here). This arbitrage premium is also called cross-currency basis. For example, a negative dollar cross currency basis means that the FX forward implied carry of a currency against the USD is larger than the corresponding on-shore short-term interest rate differential. Since the global financial crisis, 2008-09 periods of sizeable dollar cross currency basis have also been observed in developed markets. They reflect arbitrage frictions due typically to a combination of regulatory restrictions and short-term funding pressure (view post here). In most cases, a negative dollar funding basis increases the implicit subsidy paid by the FX forward market.
FX carry trades also illustrate the inherent vulnerability of subsidy-based investment strategies. Positive carry typically encourages capital inflows into small and emerging markets. This helps to compress inflation and but is also conducive to a domestic asset market boom. Because of the former, the central bank does not fight the latter. In this way, FX carry strategies can produce self-validating flows. Financial markets create their own momentum. Conversely, a reversal of such flows is self-destructing (view post here).
Carry is the most popular but not the only indicator related to implicit subsidies in FX markets. Another approach is estimating the hedge value of currencies. Depending on circumstances, some currencies have a tendency to strengthen against the USD when global or U.S. equity prices fall. An expected negative correlation means that investors pay a premium for holding such a currency in a diversified portfolio. This preference translates into an implicit subsidy for those willing to short it on its own. Analogously, the expected positive correlation of a currency with equity prices means that investors require a discount for holding that currency in a diversified portfolio, which translates into a subsidy for those willing to be long. The hedge value of a currency, as priced by the market, can be inferred directly from ‘quanto index contracts’(view post here). ‘Quantos’ are derivatives that settle in currencies different from the denomination of the underlying contract.