What is a private equity fund?

Question: What is a private equity fund? What is the difference between a private equity fund and a hedge fund?

Answer: For many people who are not familiar with the alternative investment industry, hedge funds and private equity funds look like the same thing. The distinction is not necessarily in the legal structure (which is similar), but in the investment style. The GAO’s hedge fund and pension report, which I discussed recently, provided a great definition for private equity funds:

Like hedge funds, there is no legal or commonly accepted definition of private equity funds, but the term generally includes privately managed pools of capital that invest in companies, many of which are not listed on a stock exchange. Although there are some similarities in the structure of hedge funds and private equity funds, the investment strategies employed are different. Unlike many hedge funds, private equity funds typically make longer-term investments in private companies and seek to obtain financial returns not through particular trading strategies and techniques, but through long-term appreciation based on corporate stewardship, improved operating processes and financial restructuring of those companies, which may involve a merger or acquisition of companies. Private equity is generally considered to involve a substantially higher degree of risk than traditional investments, such as stocks and bonds, for a higher return.

While strategies of private equity funds vary, most funds target either venture capital or buy-out opportunities. Venture capital funds invest in young companies often developing a new product or technology. Private equity fund managers may provide expertise to a fledgling company to help it advance toward a position suitable for an initial public offering. Buyout funds generally invest in larger established companies in order to add value, in part, by increasing efficiencies and, in some cases, consolidating resources by merging complementary businesses or technologies. For both venture capital and buy-out strategies, investors hope to profit when the company is eventually sold, either when offered to the public or when sold to another investor or company. Each private equity fund generally focuses on only one type of investment opportunity, usually specializing in either venture capital or buyout and often specializing further in terms of industry or geographical area. (Other less common types of private equity include mezzanine financing, in which investors provide a final round of financing to help carry the company through its initial public offering, and distressed debt investments, in which firms buy companies that have filed for bankruptcy or may do so and then typically liquidate the company.)

Investment in private equity has grown considerably over recent decades. According to a venture capital industry organization, the amount of capital raised by private equity funds grew from just over $2 billion in 1980 to about $207 billion in 2007; while the number of private equity funds grew from 56 to 432 funds over the same time period.

As with hedge funds, private equity funds operate as privately managed investment pools and have generally not been subject to Securities and Exchange Commission (SEC) examinations. Pension plans typically invest in private equity through limited partnerships in which the general partner develops an investment strategy and limited partners provide the large majority of the capital. After creating a new fund and raising capital from the limited partners, the general partner begins to invest in companies that will make up the fund portfolio. Limited partners have both limited control over the underlying investments and also limited liability for potential debts incurred by the general partners through the fund. By Hedge Fund Lawyer

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Currency Carry Trades Deliver

Whether you invest or trade in the stock, bond, commodities or currency market, it is likely that you have heard of the carry trade. This strategy has generated positive returns since the 1980s, but only in recent years has it received much media attention. For those of you who are still befuddled by what a carry trade is and why the hysteria surrounding the trade has extended beyond the currency market, welcome to Carry Trades 101. We will explore how a carry trade is structured, when it works, when it doesn't and the different ways that short- and long-term investors can apply the strategy.

What is the carry trade?
The carry trade is one of the most popular trading strategies in the currency market. Mechanically, putting on a carry trade involves nothing more than buying a high yielding currency and funding it with a low yielding currency, similar to the adage "buy low, sell high."

The most popular carry trades are currency pairs like the Australian dollar/Japanese yen, New Zealand dollar/Japanese yen and the British pound/Swiss franc because the interest rate spreads of these currencies pairs are very high. The first step in putting together a carry trade is to find out what currency offers a high yield and what one offers a low yield.
As of June 2007, the interest rates for the most liquid currencies in the world were as follows:

New Zealand (NZD)	8.00%
Australia (AUD)	6.25%
U.K. (GBP)	5.50%
U.S. (USD)	5.25%
Canada (CAD)	4.25%
Eurozone (EUR)	4.00%
Swiss franc (CHF)	2.25%
Japanese yen (JPY)	0.50%

With these interest rates in mind, it is simple to see which countries are offering the largest and smallest yields. Traders can keep on top of these interest rate levels by either visiting DailyFX.com or by going to the websites of specific central banks. Given the fact that New Zealand and Australia have the highest yields on our list while Japan has the lowest, it is hardly surprising that AUD/JPY is the poster child of carry trades. Currencies are traded in pairs so all an investor needs to do to put on the trade is to buy NZD/JPY or AUD/JPY on his or her forex trading platform.

The Japanese yen's low selling cost is an attribute that has been capitalized by equity and commodity traders as well. Over the past few years, investors in other markets have started putting on their own versions of the carry trade by shorting the yen and buying U.S. or Chinese stocks, for example. This has fueled a huge speculative bubble in both markets as well as strong correlation between carry trades and stocks.

The Mechanics of Earning Interest
One of the cornerstones of the carry trade strategy is the ability to earn interest. The income is accrued every day for long carry trades with triple rollover given on Wednesday to account for Saturday and Sunday rolls. Roughly speaking, the daily interest is calculated in the following way:

(Interest Rate of the Currency that you are Long – Interest Rate of the Currency that you are Short) x Notional of Your Position # of Days in a Year

For 1 lot of NZD/JPY that has a notional of 100,000, we compute interest the following way:

(.8 – 0.005) x 100,000 = approximately $20 a day
365

It is important to realize that this amount can only be earned by traders who are long NZD/JPY. For those who are fading the carry, interest will need to be paid every day.

Why has a Strategy this Simple Become so Popular?
Between January 2000 and May 2007, the Australian dollar/Japanese yen currency pair (AUD/JPY) offered an average annual yield of 5.14%. For most people, this return is a pittance, but in a market where leverage is as high as 200:1, even the use of five to 10 times leverage can make that return extremely extravagant. Investors earn this return even if the currency pair fails to move one penny. However, with so many people addicted to carry trades, the currency almost never stays stationary. In the past 6.5 years, the AUD/JPY exchange rate increased 83%, bringing the cash-on-cash return on a long AUD/JPY trade to 100%. At two times leverage, that's 200%.

If It Were Only This Easy
Unfortunately, the carry trade strategy is not just about going long a currency with a high yield and shorting a currency with a low yield. It is not difficult to realize that this strategy fails instantly if the exchange rate devalues by more than the average annual yield. With the use of leverage, losses can be even more significant, which is why when carry trades go wrong, the liquidation can be devastating. Therefore, it is important to understand when carry trades work and when they fail.

When do carry trades work?

Central Bank Increasing Interest Rates: Carry trades work when central banks are either increasing interest rates or plan on increasing them. Money can now be moved from one country to another at the click of a mouse, and big investors are not hesitant to move money from one country to another in search of not only high, but also increasing, yield. The attractiveness of the carry trade is not only in the yield, but also the capital appreciation. When a central bank is raising interest rates, the world notices and there are typically many people piling into the same carry trade, pushing the value of the currency pair higher in the process. The key is to try to get into the beginning of the rate tightening cycle and not the end. (To learn more, read Trying To Predict Interest Rates and Get To Know The Major Central Banks.)

Low Volatility, Risk-Seeking Environment: Carry trades also perform well in low volatility environments because traders are more willing to take on risk. What carry traders are looking for is the yield - any capital appreciation is just a bonus. Therefore, most carry traders, especially the big hedge funds who have a lot of money at stake, are perfectly happy if the currency does not move one penny, because they will still earn the leveraged yield. As long as the currency doesn't fall, carry traders will essentially get paid while they wait. Also, traders and investors are more comfortable with taking on risk in low volatility environments. When they take on risk, it has become a habit to fund these riskier trades with short yen positions.

When do carry trades fail?

Central Bank Reduces Interest Rates: The profitability of carry trades comes into question when the countries who offer high interest rates begin to cut them. The initial shift in monetary policy tends to represent a major shift in trend for the currency. For carry trades to succeed, the currency pair either needs to not change in value or appreciate. When interest rates decrease, foreign investors are less compelled to go long the currency pair and are more likely to look elsewhere for more profitable opportunities. When this happens, demand for the currency pair wanes and it begins to sell off. Depreciation in the currency pair could easily wipe out any interest income.

Central Bank Intervenes in Currency: Carry trades will also fail if a central bank intervenes in the foreign exchange market to either stop its currency from rising or prevent it from falling further. For countries that are export dependent, an excessively strong currency could take a big bite out of exports while an excessively weak currency could lead to significant backlash. This is particularly true for the Japanese yen, the preferred funding currency, because many companies in foreign nations have complained loudly that the weakness in the Yen is making their goods less competitive in the global market. They have asked their own politicians to put pressure on the Japanese to either increase interest rates or intervene in the currency to prevent it from falling even more. Either of these tactics would strengthen the yen, which would bring down the exchange rate of carry trades. The same can be said of intervention by the Reserve Bank of New Zealand to weaken the value of the New Zealand dollar.

Best Way to Trade Carry is Through a Basket
With the pros and cons of carry trading in mind, the best way to trade carry is through a basket. When it comes to carry trades, at any point in time, one central bank may be holding interest rates steady while another may be increasing or decreasing them. With a basket that consists of the three highest and the three lowest yielding currencies, any one currency pair only represents a portion of the whole portfolio; therefore, even if there is carry trade liquidation in one currency pair, the losses are controlled by owning a basket. This is actually the preferred way of trading carry for investment banks and hedge funds. This strategy may be a bit tricky for individuals because trading a basket would naturally require greater capital, but it can be done with smaller lot sizes. The key with a basket is to dynamically change the portfolio allocations based upon the interest rate curve and monetary policies of the central banks.

Benefiting from the Carry Trade
The carry trade is a long-term strategy that is far more suitable for investors than traders because investors will revel in the fact that they will only need to check price quotes a few times a week rather than a few times a day. True carry traders, including the leading banks on Wall Street, will hold their positions for months (if not years) at a time. The cornerstone of the carry trade strategy is to get paid while you wait, so waiting is actually a good thing.

Partly due to the demand for carry trades, trends in the currency market are strong and directional. This is important for short-term traders as well because, in a currency pair where the interest rate differential is very significant, it may be far more profitable to look for opportunities to buy on dips in the direction of the carry than to try to fade it. For those who insist on fading AUD/JPY strength for example, they should be wary of holding short positions for too long because with each passing day, more interest will need to be paid. The best way for shorter term traders to look at interest is that earning it helps to reduce your average price while paying interest increases it. For an intraday trade, the carry will not matter, but for a three-, four- or five-day trade, the direction of carry becomes far more meaningful.

by Kathy Lien

Kathy Lien is Chief Strategist at the world's largest retail forex market maker, Forex Capital Markets in New York. Her book "Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Swings" (2005, Wiley), written for both the novice and expert, has won much acclaim. Easy to read and easy to apply, this book shows traders how to enter the currency market with confidence - and create long-term success! Kathy has taught currency trading seminars across the U.S. and has also written for CBS MarketWatch, Active Trader, Futures Magazine and SFO Magazine. Follow her blog at www.kathylien.com

READ MORE - Currency Carry Trades Deliver

Currency Crosses

After going through the School of Pipsology and doing a little demo trading, there’s probably one thing you’ve noticed about trading currencies – it’s all about the US Dollar! Or is it?
Well, with central banks across the world holding trillions in USD reserves, commodities priced in the Greenback, and other major financial transactions passing through the dollar daily, it pretty much IS all about the dollar. 


In general, approximately 90% of all transactions in the almost US$2 trillion daily traded Foreign Exchange market involves the dollar. Wow!
Also, in your demo trading, I’m sure you’ve noticed that no matter what major pair you trade (i.e. EURUSD, AUDUSD, USDCHF, etc.) that US news pretty much dominates the movement regardless of data releases from anywhere else. So, why look at anything else besides the major currency pairs?

Well, serious trading opportunities can be found by following the other major currencies with currency crosses, especially if you want to avoid the unpredictable volatility that US dollar can bring.
Hopefully, this lesson will open up your outlook on Crosses and give you basic understanding on how to analyze them.

What is a Currency-Cross?
Basically, a currency-cross is any currency pair in which the US Dollar is neither the base nor counter currency. For example, GBPJPY, EURJPY, EURCAD, and AUDNZD are all considered currency crosses.

Back to Basics

When it comes down to it, currency trading is all about matching weak currencies and strong currencies.
Just find a country that has weak a fundamental outlook or maybe a distressful political situation, and then match it with a country with positive or better fundamentals (i.e. rising employment, growing trade surplus, etc) or maybe a positive political outlook, then you can match their currencies together to make an intelligent directional trade.


Let’s take a look at a recent, real world example:
On January 11th, 2007, both the Bank of England and the European Central Bank were set to release their decisions on their interest rate policy. Leading up to that morning, the markets speculated that the ECB hint that they would raise interest rates soon and the BoE would hold any hikes. Well, what a surprise the market got as the Bank of England raised rates to 5.25% and the ECB held rates at 3.50% on concerns of slowing growth in the Eurozone.
So, why would a currency trading pro, such as yourself, play a currency cross instead of matching either the Euro or the British Pound with the US Dollar? Well, here are a couple of scenarios to think about:

1. US Retail sales numbers were coming out soon after the interest rate decisions. If you had a weak outlook on the Euro and went short EURUSD, then a weak US Retail report would probably been bad for your trade as the US dollar would sell off.
2. Or if you maintained a strong outlook on the British Pound and decided to go long GBPUSD, then a dollar rally on a strong US retail sales report would have been very bad for you trade.

After the interest rate releases, we know the outlook on the Euro is weaker and the outlook of the British Pound is stronger, why don’t we just short EURGBP? By taking this trade you get rid of the event risk of upcoming US data, plus you get a positive carry on your position!
Here’s how you may have faired taking a short trade on EURGBP using this analysis:

















As you can see from the chart, had you shorted at 0.6650 an hour or so after the interest rate decisions were announced, you would have caught the slow and steady move to 0.6600, and possibly further until fundamentals change for either the Euro or the Pound.
Again, this is just one example of matching weak with relatively stronger currencies. With six major currencies other than the US dollar, there are plenty of possibilities to find profitable trades, and avoid erratic volatility with the US dollar.

Synthetic Pairs

You’ve done your analysis and you’ve come to the conclusion that the British Pound looks strong and the Swiss Franc may get weaker.
Or maybe the Australian dollar is looking pretty good against the Canadian dollar, but you look in your trading platform and see that your broker doesn’t have GBPCHF or AUDCAD.
Oh no! I guess that’s an opportunity missed, right? Heck No! You can create a “synthetic” pair to go long on GBPCHF or AUDCAD.

To create synthetic pairs using the four major currency pairs and three commodity currencies is relatively easy. All it takes is to buy or sell two pairs with equal position sizes.
Let’s say you want to go long the British Pound against the Swiss Franc, or buy GBPCHF.
You would have to buy GBPUSD and buy USDCHF at the same time. Still not clear? Let me show you…

Pretty simple, right? The only trick to it is making sure you buy the same amount of each pair.
Using our GBPCHF example, let’s say the current exchange rate for GBPUSD is 1.9000 and the exchange rate for USDCHF is 1.2500 and you want to buy US$10,000 worth of each pair. Here’s how you do it:

For pairs with USD as the counter currency (i.e. AUDUSD, GBPUSD, EURUSD, etc.), then you would take the dollar amount you want to purchase and divide it by the exchange rate:
US$10,000 (desired position size) divided by 1.9000 (current rate of GBPUSD) = 5263 Units of GBPUSD

For pairs with USD as the base currency (i.e. USDCHF, USDJPY, USDCAD), just purchase amount of units you want to buy because you are buying US dollars
$10,000 (desired position size) * 1 Unit = 10,000 Units
So, to buy US$10,000 worth of GBPCHF, we purchase 5,263 units of GBPUSD (if your broker doesn’t offer flexible lot sizes you can always round up or down) and 10,000 units of USDCHF. Got it? Great! I knew you would!

Summary

As you can see, there are many, many trade opportunities presenting themselves in the foreign exchange market other than figuring out what the Greenback will do any given day - and now you know how to find them! Just remember a few things:

• Do your due diligence/analysis and match the weak currencies with strong currencies.
• What if the pair you are looking to trade is not available with your broker, no sweat right? You now know how to create synthetic pairs by simultaneously going long or short two major pairs to create one currency cross.
• Last tip; please be conscientious of the pip value of the cross you are trading. For example, a standard lot (100,000 units) of EUR/GBP will be approximately $19.70 per pip. Some crosses will have a higher or lower pip value than the majors. This information is good to know for your risk analysis.

So, on the days you many not see any opportunities in the major pairs, or if you want to avoid the volatility of a US news event, check out some the currency crosses. You may never know what you may find! Good luck!

www.babypips.com

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Getting a lift from the carry trade

Correctly assessing the risk environment paves the way to capitalizing on the interest-rate differentials between currencies. BY KATHY LIEN

Just as markets that offer the highest returns will attract the most volume, so, too, in the world of international capital flows, nations that offer the highest interest rates will generally attract the most investment and create the most demand for their currencies.

The “carry trade” is a forex strategy based on this reality. Although it is particularly popular among global macro hedge funds, it is actually very simple to understand and execute. Carry trades involve buying (or lending) a currency with a high interest rate and selling (or borrowing) a currency with a low interest rate. With lackluster equity market performance and progressively lower yields from the U.S. bond market as a result of interest rate cuts by the U.S. Federal Reserve, this strategy’s popularity surged in 2002. As money piled into carry trades, unhedged traders enjoyed earning yield and capital appreciation.

If executed correctly, an investor can earn a high return without taking on excessive risk. However, the chances of loss are great if you do not understand how, why and when carry trades work best.

How do carry trades work?

Traders looking to “earn carry” will buy a high-yielding currency while simultaneously selling a low-yielding currency. Carry trades are profitable because an investor is able to earn the difference in interest (the spread) between the two currencies as well as, ideally, capital appreciation. Table 1 lists the interest rates of several major countries as of Sept. 22.

TABLE 1 — GLOBAL INTEREST RATES
Country	Interest rate
New Zealand (NZD)	6.25%
Australia (AUD)	5.25%
United Kingdom (GBP)	4.75%
Canada (CAD)	2.25%
Europe (EUR)	2.00%
United States (USD)	1.75%
Japan (JPY)	0.00%
Switzerland (CHF)	0.75%
*As of Sept. 22, 2004

The reason this trade is so popular is because it’s not limited to speculators.Imagine you are an investor in Switzerland who is earning an interest rate of 0.75-percent per year on your bank deposit denominated in Swiss francs (CHF). At the same time, a bank in Australia is offering 5.25 percent per year on a deposit denominated in Australian dollars (AUD). Seeing that interest rates are much higher at the Australian bank, wouldn’t you want to convert your Swiss francs into Australian dollars?

Large investors who are able to move money freely across borders will take advantage of higher yields offered abroad. By trading their deposit of Swiss francs paying 0.75 percent for a deposit of Australian dollars paying 5.25 percent, what these investors have effectively done is “sell” their Swiss franc deposit, and “buy” an Australian dollar deposit.

After this transaction they now own an Australian dollar deposit that pays 5.25 percent in interest per year — 4.50 percent more than the Swiss franc deposit. This is a carry trade. The net effect of millions of people doing this transaction is that capital flows out of Switzerland and into Australia as investors take their Swiss francs and trade them for Australian dollars. Australia attracts more capital because of the higher rates it offers.

This capital inflow increases the value of the currency Aside from earning the 4.50- percent interest rate differential, traders engaging in such unhedged carry trades are also hoping, as in this example, their Australian dollar deposits appreciate in value against the Swiss franc.

Let’s look at another example. Assume the British pound (GBP) offers an interest rate of 4.75 percent, while the Swiss franc offers an interest rate of 0.75 percent. To execute the carry trade, an investor buys the British pound and sells the Swiss franc — or, buys the GBP/CHF currency pair (see Figure 2). In doing so, he or she can earn a profit of 4 percent (4.75 percent in interest earned minus 0.75 percent in interest paid), as long as the exchange rate between the British pound and Swiss franc remains stable.

The leveraged carry trade

Now, a 4-percent annualized yield may not sound very attractive, but when you factor in leverage, the profits are noticeably higher (as are the risks). Although many FX firms offer up to 200:1 leverage, we will look at a more conservative example that employs 20:1 leverage.

Let’s say you have $5,000 to invest and decide to put $1,000 of that into a carry trade. The original 4.75 percent yield would earn you $47.50 over the course of the year or approximately $0.13 per day. With 20:1 leverage, the buying power of your $1,000 becomes $20,000. Interest then becomes $950 per year or $2.64 per day on the original investment — a return of 95 percent. Now here is where we insert the caution statement: This scenario works only if the underlying values of the currencies do not move — which of course is not possible. Currency values fluctuate every second. Therefore, using higher leverage also means you incur the possibility of larger losses.

For example, instead of a 10-pip (or point) fluctuation in the euro-U.S. dollar rate (EUR/USD) representing $1, 20:1 leverage magnifies it to $20 — and currencies will fluctuate dramatically. Between September 2003 and July 2004, the Australian dollar strengthened nearly 15 percent against the U.S. dollar (see Figure 3, p. 7). If you factor in the currency appreciation and interest rate return on leverage, the profits can be sizeable. However, 15 percent depreciation could have just as easily occurred, which would significantly hurt a leveraged trade.

Because most traders engaging in this type of strategy are looking to earn both yield and the appreciation of the currency pairs, the next question is, how do you determine the type of environment in which carry trades will

perform well?

When will carry trades work best?

Carry trades generally are most profitable when investors as a whole have a very specific attitude toward risk. Psychology drives the markets and people’s moods tend to change over time. Sometimes they may feel more daring and willing to take chances, other times they may be more timid and conservative. Investors, as a group, are no different. Sometimes they are willing to make relatively high risk investments, other times they are morefearful and seek safer assets. 

When investors as a whole are willing to assume risk, we say they have low risk aversion, or, in other words, they are comfortable taking risk. When investors re drawn to more conservative investments and are less willing to take on risk, we say they have high risk aversion (see Table 2).

TABLE 2 — CONDITIONS FOR CARRY TRADE
Carry trade profitability
(-)	(+)
High risk aversion	Low risk aversion
Investors are less willing to take risks; they remove funds from risky currencies.	Investors are more willing to take risks.
Capital flows out of riskier high-interest currencies and into low-interest, “safe-haven” currencies	Capital flows away from low-interest currencies and into those that pay higher interest rates
Low-interest currencies appreciate as investors get out of risky trades	Low-interest currencies tend to remain weak, and are used to finance risky trades.
Source: FXCM

Carry trades are most profitable when investors have low risk aversion, which makes sense when you consider what a carry trade involves. When buying a currency with a high interest rate, the investor is taking a risk — there is uncertainty about whether the country’s economy will continue to perform well and be able to pay high interest rates.

Countries with better growth prospects can afford to pay higher interest rates on the money that is invested in them, but there is always a chance something might change. Ultimately, investors must be willing to take this chance. If investors as a whole were not willing to take on this risk, then capital would never move from one country to another, and the carry-trade opportunity would not exist.

Other considerations

While risk aversion is one of the most important things to consider before making a carry trade, it is not the only one. Here are some additional issues to take into account.

Low interest rate currency appreciation: Even if market participants are in risk-seeking mode, there are factors that can lead to a rally in the currency with the lower interest rate. When the low interest rate currency in a carry trade (the currency being sold) appreciates, it negatively affects the profitability of the carry trade.

For example, geopolitical risks or fears of terrorism tend to have a positive affect on the Swiss franc, which is widely considered the “safe-haven” currency. In Japan, although interest rates are low, increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market.

Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades such as the Australian dollar (high interest rate) vs. Japanese yen.

Trade balances: Trade balances (the difference between a country’s imports and exports) can also affect the profitability of a carry trade. When investors have low risk aversion, capital will typically flow from the low interest rate paying currency to the high interest rate paying currency. However, this does not always happen.

To understand why, consider that even though Japan currently pays historically low interest rates, there is strong demand for the Japanese yen. Although this can be attributed partially to the country’s recent recovery, a more important factor is Japan’s huge trade surplus. There is strong foreign demand for Japanese goods — electronics, cars, etc. As a result, although the country offers low rates of return, Japan attracts trade flows into the yen. The point is that even when investors have low risk aversion, large trade imbalances can cause a low interest rate currency to appreciate.

Time-horizon: In general, a carry trade is a long-term strategy. Before entering into a carry trade, an investor should be willing to commit to a time horizon of at least six months. This commitment helps to make sure the trade will not be affected by the “noise” of shorter-term currency price movements.

When to close the carry trade

Because carry trades are least profitable when investors are highly risk averse, traders who already have carry trades must stay abreast of the risk environment and prepare for when it changes.

Investors’ willingness to make risky trades can change dramatically from one moment to the next. Often such large shifts are caused by significant global events. When investor risk aversion does rise quickly, the result is generally a large capital inflow into low-interest rate, “safe-haven” currencies.

Such conditions can set the stage for carry trades to lose money. For example, in the summer of 1998 the Japanese yen appreciated against the dollar by more than 20 percent in two months, mainly because of the Russian debt crisis and the LTCM hedge-fund bailout. Similarly, just after the Sept. 11, 2001, terrorist attacks, the Swiss franc rose by more than 7 percent against the dollar over a 10-day period.

Bottom line

The leveraged carry trade strategy is still very popular in the currency markets. By properly assessing the risk environment, traders can increase the probability of successfully executing the carry trade strategy.

Kathi Lien – activetrademag.com

READ MORE - Getting a lift from the carry trade

Currency correlation

Some currencies tend to move in the same direction, some — in opposite. This is a powerful knowledge for those who trade more than one currency pair. It helps to hedge, diversify or double profitable positions.

Statistically measured by performance, currency pairs are given so called "correlation coefficients" from +1 to -1.

A correlation of +1 means two currency pairs will move in the same direction 100% of the time. A correlation of -1 means they will move in the opposite direction 100% of the time. A correlation of zero means no relation between currency pairs exists. Information about current correlation coefficients can be found here: Currency Correlations Table

The example of strong positive correlation between two currency pairs is: GBP/USD and EUR/USD. They have a correlation coefficient of over +0.90, which means that when EUR/USD goes up, GBP/USD also goes up.
A well known sample of two opposite moving currency pairs is EUR/USD and USD/CHF, they have very high coefficient of over -0.90, which means that they move inversely almost 100% of the time!

Examples of same direction moving currency pairs are:

EUR/USD and GBP/USD
EUR/USD and NZD/USD
USD/CHF and USD/JPY
AUD/USD and GBP/USD
AUD/USD and EUR/USD

Inversely moving pairs are:
EUR/USD and USD/CHF
GBP/USD and USD/JPY
GBP/USD and USD/CHF
AUD/USD and USD/CAD
AUD/USD and USD/JPY

How a trader can use this information?

1. A very simple use is avoiding trades that cancel each other. For instance, knowing that EUR/USD and USD/CHF move inversely near-perfectly, there would be no point to go short on both positions as they eventually cancel each other (loss + profit).

1.a. However, there is a strategy of hedging one currency pair with another. Lets' take the same pairs: EUR/USD and USD/CHF. For example, a trader has opened long positions on both currency pairs. Since they move in opposite directions, if EUR/USD is making some losses, the other pair will go in profit. Hence, the total loss will not be as bad as if it would be without the second "backup trade". On the other hand, profits here are not large either.

2. When confident, a trader may double position size by placing same orders on parallel (moving in the same direction) currency pairs.

3. Another option would be to diversify risks in trade. For instance, AUD/USD and EUR/USD pairs have the correlation coefficient of about +0.70 which means that pairs are moving mostly in the same direction but not as perfect (which is what we need here). If we decide that USD is going to weaken, for example, we will go long and place half of buy order on AUD/USD currency pair, and half on EUR/USD. Splitting the orders will preserve trader's positions from sudden losing rallies (sudden "jumps" in price); and as these currencies move not 100% identical a trader will have some time to react adequately. Different monetary policies of different countries' banks also create an impact: when one currency will be less affected than the other and therefore will move slower.

Good trades!
FX Leader

source : http://www.forexmarkethours.com

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Currency Pair Correlations

Sometimes the charts of different currency pairs echo each other’s movements, and sometimes they seem to move as opposites. This phenomenon is known as positive or negative correlation within the forex trading market, and it can be a powerful tool for savvy traders.

There are all sorts of reasons for correlation, for example, different monetary policies, changes in commodity prices, and various economic and political situations.

With the fluidity of global economics, such as diverging monetary policies between nations and the ups and downs of the commodities markets, correlation between sets of currency pairs does change over time. However, certain trends tend to remain static. For example, NZD/USD and AUD/USD tend toward fairly strong positive correlation despite the significant differences in the economic situations of Australia and New Zealand.

On the other hand, EUR/USD and USD/CHF generally have a fairly strong negative correlation, with the lower liquidity of the Swissie giving it greater volatility. Therefore, when the USD/CHF is bullish, traders historically expect the EUR/USD to become bearish, and vice versa.

Statistical techniques have been established to measure degrees of correlation. The most commonly used system illustrates that degree with a coefficient between +1 and –1, where +1 indicates two currency pairs that move in perfect synchronisation, –1 indicates two currency pairs that move as mirror images, and 0 indicates there is no correlation between the two pairs and they move at random.

There are many sets of correlation tables for the most actively traded currency pairs available online, so there’s no need for each trader to calculate their own set to trade the majors. However, for less actively traded currency pairs, calculating correlations can be accomplished with a spreadsheet program such as Excel and by downloading historical price tables from one’s online forex trading platform.

Correlation is calculated over different periods of time, with the most common intervals being one month, three months, six months, and one year. Comparing degrees of correlation over time emphasizes the overall volatility of the forex trading market and helps traders to plan their portfolio, particularly as regards exposure.

Correlation is important for all traders. Technical analysts know that, when the chart of one currency pair shows a certain promising pattern, strongly correlated pairs are also worth examining. As a hypothetical example, if EUR/USD signals a break above a trendline, one should examine GBP/USD for a similar pattern, and USD/CHF for its reverse.


The fundamental analyst can use correlation in several ways. First, knowing currency pair correlations helps one avoid contradictory positions, e.g., going long on both the EUR/USD and USD/CHF makes no sense as with their strong negative correlation, the loss suffered from one trade would cancel out the profit earned from the other.

Another fundamental use for correlation is to diversify one’s portfolio by using currency pairs with strong but not absolute correlation to strengthen one’s position within the market. An example would be going long on both the EUR/USD and GBP/USD. With a positive correlation of 0.71 over the twelve months preceding November 2007, holding such a position spreads the trader’s risk while still remaining USD bearish overall.
source : http://forextradings.com.au

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Using Currency Correlations To Your Advantage

by Kathy Lien,Chief Strategist, FXCM

To be an effective trader, understanding your overall portfolio's sensitivity to market volatility is important. But this is particularly so when trading forex. Because currencies are priced in pairs, no single pair trades completely independently of the others. Once you know about these correlations and how they change, you can take advantage of them to control over your portfolio's exposure.
 
Defining Correlation The reason for the interdependence of currency pairs is easy to see: if you were trading the British pound against the Japanese yen (GBP/JPY pair), for example, you are actually trading a kind of derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. However, the interdependence among currencies stems from more than the simple fact that they are in pairs. While some currency pairs will move in tandem, other currency pairs may move in opposite directions, which is in essence the result of more complex forces.

Correlation, in the financial world, is the statistical measure of the relationship between two securities. The correlation coefficient ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.

Reading The Correlation Table With this knowledge of correlations in mind, let's look at the following tables, each showing correlations between the major currency pairs for the month of March 2005.


The upper table above shows that over the month of March (one month) EUR/USD and AUD/USD had very strong positive correlation of 0.94. This implies that when the EUR/USD rallies, the AUD/USD will also rally 94% of the time. Over the longer term (three months), though, the correlation is slightly weaker (0.47).
In contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of -0.99. This implies that 99% of the time, when the EUR/USD rallies, USD/CHF will undergo a selloff. This relationship even holds true over longer periods as the correlation figures remain relatively stable.


Yet correlations do not always remain stable. Take USD/CAD and NZD/USD, for example. With a coefficient of -0.94, they had a strong negative correlation over the past year, but the relationship deteriorated over March 2005 for a number of factors, including the Reserve Bank of New Zealand's intentions to resume rate hikes, and political instability in Canada.
 
Correlations Do Change
It is clear then that correlations do change, which makes following the shift in correlations even more important.Sentiment and global economic factors are very dynamic and can even change on a daily basis.Strong correlations today might not be in line with the longer-term correlation between two currency pairs.That is why taking a look at the six-month trailing correlation is also very important.This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate.Correlations change for a variety of reasons, the most common of which include diverging monetary policies, a certain currency pair’s sensitivity to commodity prices, as well as unique economic and political factors.

Here is a table showing the six-month trailing correlations that EUR/USD shares with other pairs:



Calculating Correlations Yourself The best way to keep current on the direction and strength of your correlation pairings is to calculate them yourself. This may sound difficult, but it's actually quite simple.

To calculate a simple correlation, just use a spreadsheet, like Microsoft Excel. Many charting packages (even some free ones) allow you to download historical daily currency prices, which you can then transport into Excel. In Excel, just use the correlation function, which is =CORREL(range 1, range 2). The one-year, six-, three- and one-month trailing readings give the most comprehensive view of the similarities and differences in correlation over time; however, you can decide for yourself which or how many of these readings you want to analyze.

Here is the correlation-calculation process reviewed step by step:

1. Get the pricing data for your two currency pairs; say they are GBP/USD and USD/JPY
2. Make two individual columns, each labeled with one of these pairs. Then fill in the columns with the past daily prices that occurred for each pair over the time period you are analyzing
3. At the bottom of the one of the columns, in an empty slot, type in =CORREL(
4. Highlight all of the data in one of the pricing columns; you should get a range of cells in the formula box.
5. Type in comma
6. Repeat steps 3-5 for the other currency
7. Close the formula so that it looks like =CORREL(A1:A50,B1:B50)
8. The number that is produced represents the correlation between the two currency pairs

Even though correlations do change, it is not necessary to update your numbers every day, updating once every few weeks or at the very least once a month is generally a good idea.
How To Use It To Manage Exposure Now that you know how to calculate correlations, it is time to go over how to use them to your advantage.

First, they can help you avoid entering two positions that cancel each other out, For instance, by knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time, you would see that having a portfolio of long EUR/USD and long USD/CHF is the same as having virtually no position - this is true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/USD is similar to doubling up on the same position since the correlation is so strong.

Diversification is another factor to consider. Since the EUR/USD and AUD/USD correlation is traditionally not 100% positive, traders can use these two pairs to diversify their risk somewhat while still maintaining a core directional view. For example, to express a bearish outlook on the USD, the trader, instead of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot of the AUD/USD. The imperfect correlation between the two different currency pairs allows for more diversification and marginally lower risk. Furthermore, the central banks of Australia and Europe have different monetary policy biases, so in the event of a dollar rally, the Australian dollar may be less affected than the Euro, or vice versa.

A trader can use also different pip or point values for his or her advantage. Lets consider the EURUSD and USDCHF once again. They have a near-perfect negative correlation, but the value of a pip move in the EURUSD is $10 for a lot of 100,000 units while the value of a pip move in USDCHF is $8.34 for the same number of units. This implies traders can use USDCHF to hedge EURUSD exposure.

Here's how the hedge would work: say a trader had a portfolio of one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When the EUR/USD increases by ten pips or points, the trader would be down $100 on the position. However, since USDCHF moves opposite to the EURUSD, the short USDCHF position would be profitable, likely moving close to ten pips higher, up $83.40. This would turn the net loss of the portfolio into minus $16.60 instead of minus $100. Of course, this hedge also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst-case scenario, losses become relatively lower.

Regardless of whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to be aware of the correlation between various currency pairs and their shifting trends. This is powerful knowledge for all professional traders holding more than one currency pair in their trading accounts. Such knowledge helps traders, diversify, hedge or double up on profits.

Summary To be an effective trader, it is important to understand how different currency pairs move in relation to each other so traders can better understand their exposure. Some currency pairs move in tandem with each other, while others may be polar opposites. Learning about currency correlation helps traders manage their portfolios more appropriately. Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

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