Can ETCs replicate the carry trade?

By Felix Salmon
November 16, 2009
Denise Law ran an article about a set of new currency ETCs which are going to be listed on the London stock exchange -- think ETFs, but for foreign exchange. She quoted Nik Bienkowski, the chief operating officer at ETF Securities, which has created these instruments:

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Now I’m confused. Back on November 6, the FT’s Denise Law ran an article about a set of new currency ETCs which are going to be listed on the London stock exchange — think ETFs, but for foreign exchange. She quoted Nik Bienkowski, the chief operating officer at ETF Securities, which has created these instruments:

“The benefit of a currency ETC is that it provides exposure to local interest rates. It’s safer than putting money in a foreign bank account,” Mr Bienkowski said.

Is this an interesting new way to play the carry trade? As a good blogger should, the FT’s Izabella Kaminska revisited the subject on Friday, and found all manner of reasons why small investors should stay away from this product. Most startlingly, she writes of the maximum upside from investing in these things, that they have

all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then).

So which is it? Does the ETC provide exposure to local interest rates, or does it pay not interest or dividend at all? The official website for these things says that they “reflect movements in exchange rates between two currencies, plus exposure to local interest rates”, which seems pretty clear. But Index Universe says something rather different:

Each ETC will track the total return version of one of the Morgan Stanley Foreign Exchange (MSFX) indices. The total return index for any given currency pair has two components: a constant (long or short) position in the relevant MSFX currency, achieved by daily rebalancing via a “spot-next” transaction, and an interest component which tracks the one-month US dollar Treasury bill rate.

That’s certainly the impression I get from the official MSFX documentation:

For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily at the One-Month T-Bill Rate… Hence, the daily return on the related MSFX Total Return Index will be computed as the sum of the MSFX Currency return and the One-Month T-Bill return.

There certainly doesn’t seem to be any mention of local interest rates there. And given how much one-month Treasury bills are likely to yield for the foreseeable future, you’re not going to get much in the way of interest on that front, either.

So I’m confused about why and how ETF Securities is claiming that ETCs provide exposure to local interest rates. Is there something I’m missing here?

Update: I understand them now. And yes, they do provide exposure to local interest rates. Or they’re designed to, anyway.

5 comments

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You are earning the local interest rate, because every day you buy the foreign currency at the spot-next rate and then the next day you sell it at the spot rate. The difference between the spot-next and the spot rates is the one-day interest differential between the USD and the foreign currency. So you earn US interest rates plus the difference between foreign and US interest rates, which is just the foreign interest rate.

Posted by Daniel | Report as abusive

Perhaps it depends on your definition of “local”?

Yup, from going through the prospectus they seem only to have exposure to US Treasuries (as per the methodology of the indices), which of course is not the equivalent of playing the carry-trade.

Posted by Izabella Kaminska | Report as abusive

Just saw Daniel’s comment which relates to:

“For the deliverable MSFX Currencies, the related MSFX Excess Return Indices will replicate the return on a
constant position in the related MSFX Currency. In order to avoid physical delivery of the MSFX Currency,
the related MSFX Indices will be rebalanced daily on each Index-Good Day (as defined herein) via a “Spot
Next” or “Tom Next” transaction (as described below).”

but..

“For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to
replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily
at the (i) One-Month T-Bill Rate (“T-Bill”), in the case of the MSFX Currencies valued relative to the U.S.
dollar and (ii) Euro Overnight Index Average rate (“EONIA”), in the case of the in the case of the MSFX
Currencies valued relative to the Euro. Hence, the daily return on the related MSFX Total Return Index will be
computed as the sum of the MSFX Currency return and the One-Month T-Bill return or EONIA return, as
applicable.”

As I understand it to avoid physical delivery, the positions are being re-balanced every day. Which means that every day Morgan Stanley has to sell the prompt position for the next spot position. If the market is pricing in a contango as defined by the current cost of money then the overnight rate you receive would have to compensate for cost of rolling that position on a daily basis. Generally speaking currency markets are always either in contango or at best flat. So yes, even if you earn an overnight interest, that has to be higher than the cost of rolling to give you the benefit of the carry trade. Problem is, the forward market usually accounts for this, so the next day’s contract will be that much more expensive. So what you would receive in interest is eroded by the higher value of the contract you’re rolling into– negating any carry returns.

It’s not the same as borrowing at zero interest and investing in 10-year Australian bonds which are currently yielding 5.47%. And if that logic doesn’t convince you, overnight rates still don’t compare as RBA overnight rates currently work out to be 3.50% per annum according to the RBA website.

This means the main interest you receive is via your 1-month T-bill exposure.

At least that is how I understand. If I’ve misunderstood please do correct me.

Posted by Izabella Kaminska | Report as abusive

Does anyone know how to go about getting a Yen mortgage to purchase UK property, as a way to profit on a potentially weakening Yen in the longterm?

Posted by AndyTal | Report as abusive