Sunday, January 22, 2012

CBN Carry Trade Index Introduction

The chart below shows the just-launched Central Bank News Carry Trade Index.  Essentially the index is an indicator of the variance between interest rates of central banks.  The "all" (81 central banks) index was recorded at 772 basis points at the end of December 2011 (up from 664 basis points at the end of December 2010).  This index shows a gradual rise in the average difference among central bank rates, driven largely by tightening among emerging market and frontier markets, while developed markets have kept monetary policy rates at all time lows.

Within the developed markets, the index had crept up through the past year, only to reverse recently as banks have opted to pre-empt adverse economic effects from the Eurozone debt crisis. The Developed market index was 228 basis points at the end of December 2011.

The frontier market index showed the most significant rise, ending at 968 basis points in Dec 11 (715 bps in Dec 10), driven by a series of significant interest rate increases with frontier markets, many of which faced a larger inflation problem due to the sensitivity of general inflation in those countries to food price inflation.

The Developed market index is likely to contract further this year as the impact of slowing growth and the downside risk presented by the sovereign debt crisis weigh on the economic growth outlook and relieve pressure on inflation.

The most significant risk to that projection is greater diversity in the economic growth and inflation path among countries; with greater diversity/lower economic correlation naturally leading to wider variance in interest rate paths and levels.

Methodology: The Central Bank News Carry Trade Index is calculated by taking the simple average of the top-half (ranked) of central bank interest rates in a group, minus the simple average of the bottom-half in that group, and multiplied by 10,000 to be expressed in basis points (also called 'pips' by forex traders).

The groups are loosely based on, but not precisely replicating, the MSCI developed and emerging market index country members, with the remainder of countries falling into the frontier (or lesser developed) countries index. The DM+EM index combines emerging and developed markets, because the countries composing that index are more practical to trade/invest in compared to frontier markets; thus the index gives an indication of what sort of opportunities carry traders might, on average, have available.

Carry Trade Explained: A carry trade is any type of trade or investment which seeks to take advantage of a difference in interest rates or yields. The basic premise is to borrow or short an instrument with a low interest rate, while simultaneously investing or going long in an instrument with a higher interest rate. The existence of a difference in interest rates is termed a 'differential'.

As market interest rates tend to follow central bank interest rates, central bank monetary policy interest rates serve as a reasonable proxy for gauging the interest rate differentials between countries. The most common carry trade is that engaged in by foreign exchange traders; who swap sums of money between currencies (borrow in the low interest rate currency and invest in the high interest rate currency).

The risks of the carry trade include interest rate risk (changes in interest rates), and market risk (changes in e.g. the exchange rate). A currency carry trade may end up making significant losses in spite of the positive carry due to a significant adverse movement in the exchange rate. Thus the carry trade, while profitable for some, can be a highly risky trade.


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