Carry Trade Hedging

Discussion in 'Options' started by toc, Oct 5, 2008.

  1. toc


    When playing the Yen carry trade i.e taking loan on Yen and converting to USD for higher interest can one hedge against the appreciation in Yen and still come out ahead by couple of percentage points.

    I am very new to options, but read somewhere that cost of hedging is roughly equal to the difference in interest rates. Does hedging via options reduce the cost of hedging or is it same as hedging using the forward contracts.

    Also when using option will it be a perfect i.e. atleast 99% hedge or some risk is still left to deal with.

    Thanks All! :D
  2. A currency forward must have this carry baked into it, otherwise the couterparty trading the forward is getting automatically ripped off by you! In other words think of it in steps:
    1) take the loan in JPY
    2) sell the JPY to buy USD
    3) make a loan in USD
    4) The loans in step 1) and step 3) should match durations because otherwise you are holding the bag.
    5) Take a guess about the currency trade inbetween? You need to make an agreement to give back the JPY you borrowed in 1), so the currency trade is required to be "undone" on the same day. That's a currency forward. Guess how your couterparty will price it? So that you can't get any free cash.

  3. toc


    That's why hedging with forward contracts does not make sense especially when putting interest rate differentials on the mind.

    No free cash with foward contracts.....tough titties! :D
  4. The swap is built into the price of the option too. No such thing as a free lunch.

    You dont have to take a lone, you just need to be long yen and hedge the delta risk another way.
  5. toc


    'hedge the delta risk another way'

    any suggesstions?
  6. Sometimes I think that hedging this sort of trade with a butterfly could have a bit of an edge. I haven't traded around butterfly enough to know how to adjust. I'm sure that like all ohter trades good adjusting will be the key to profits.
  7. toc


    how about hedging via a one option and pay and sell another and receive and thus cancelling out most of the hedging cost.

    am very new to options, so if butterfly means the same as collar then :D :D :D :D :D :D :D :D :D
  8. MTE


    As others have mentioned, it doesn't work this way. You can't have your cake and eat it too.
  9. Yes it's true that there is no free lunch, but I understand what is trying to be accomplished here. I have looked into this somewhat. I know that I originally heard about this concept awhile ago from a guest. I don't remember his name, but all of there interviews are archived. He said that he bought the spot fx and sold the deep in the money call against it. This would enable him to hedge the price risk and let him earn the daily interest.

    I don't think he mentioned which forex broker offered the options however. The problem is finding good forex options to trade. I have read to many horror stories about forex brokers screwing people on the spot price side alone, let alone any options.

    That leaves the new listed fx options traded through traditional brokers. I have traded the EUI (USD/EUR) somewhat. The interest is absolutely built into it. Deep in the money puts actually can have negative extrinsic value due to the interest that should be paid them. But I think what we are getting at is whether a deep ITM call far enough out would still have enough time value to offset the interest rate differentials. Unfortunately there are only the USD options at the this time. No GBP/JPY or NZD/JPY.

    Using the XDB ( GBP/USD). Spot is 173.75. The 167 Nov call (46 days to expiration) has 1.55 in extrinsic value. So you could buy one mini lot and sell 1 call against it and you would be hedged down to 167. Not only would you make the daily rollover, but you would also get the $155 in extrinsic value is it was above 167 at expiration. So it can work. Another good one would be the XDA (AUD/USD). Although today due to the huge dollar rally, there are actually no in the money calls. I have watched this a little and I think the market makers purposefully don't offer deeper in the money calls for this reason. They know people will hedge them with the spot market.

    The drawdowns to this strategy are namely the huge margin requirements of selling a naked option. To hedge one mini GBP/USD contract you would need over $3500 in margin. Also the spread on the 167 call is currently a ridiculous 40 cents. Also you will not be protected if the spot price goes below 1.67. Also you will need to figure out how you will close the position, since they will not offset each other. Besides, being assigned on an option at Think or Swim is a $15 fee, which I've always thought of as a rip off, but that's just me. You could just try to roll it over to the next month, but of course then you're paying the spread to both close and open a position.

    I hope this helps you.
  10. The swap is priced into all the FX options both listed and OTC so the deeps wont help you.
    #10     Oct 6, 2008