Carry trades and hedging

Stephen Jen and Luca Bindelli argue in a post at the Morgan Stanley Global Economic Forum that currency hedging produces much of the effects that are commonly attributed to carry trades. Jen and Luca Bindelli are absolutely right in arguing that:

• The magnitude of gross cross border asset positions has become very large.
• Some of these cross border positions are hedged against currency risk using short term forward contracts.
• A short term forward contract is economically equivalent to a short position in the T-Bill of one currency combined with a long position in the T-Bill of the other currency.
• This position is functionally equivalent to the carry trade if the short position is in the low yielding currency and the long position is in the high yielding currency.

However, to replicate the carry trade effect, Jen and Bindelli need to make the further assumption that the hedge ratio depends on the cost of hedging as measured by interest rate differentials. I would argue that the part of the hedge that depends on interest rate differentials is a speculative position masquerading as a hedge. In Black’s universal hedging model (“Equilibrium Exchange Rate Hedging”, Journal of Finance, 45(3), 899-907) the hedge ratio is a constant across all currency pairs and the primary reason for the hedge ratio to differ from unity is Siegel’s paradox. Even if one employs more general models, it is difficult to see a role for interest rate differentials in determining the optimal hedge ratio if one assumes that the forward rates are equilibrium rates.

The assumption that forward rates are incorrect and therefore (via interest rate parity) that interest rate differentials are irrational, is a speculative position which is the core of the carry trade phenomenon. It is difficult to regard this as hedging.

Posted at 12:18 pm IST on Sat, 8 Sep 2007         permanent link

Comments