Understanding currency ETCs

By Felix Salmon
November 17, 2009
confused yesterday about currency ETCs; after a detailed conversation with Nik Bienkowski of ETF Securities, I think I understand them a bit better.

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I was confused yesterday about currency ETCs; after a detailed conversation with Nik Bienkowski of ETF Securities, I think I understand them a bit better.

The answer to my central question about whether you can try to play the carry trade with these things is quite clear: it’s yes. The mechanism is just as commenter Daniel described it: the funds essentially buy currency forwards expiring tomorrow, sell them just before expiry, and roll over into a new short-dated forward. These forwards are extremely liquid, and since that constant rolling one-day exposure in the forwards market does an excellent job of reflecting the differences in local interest rates.

As a result, says Bienkowski, if the Aussie dollar ETC had existed for the past five years, holding it would have returned 4.8% per annum, before fees, over and above whatever you would have got from holding Aussie dollars alone. Fees are 39bp per year, accrued daily, so you genuinely can get a bit of carry out of these things.

So what’s all this about T-bill interest rates? It all comes down to the nature of the derivatives market. If I’m buying a forward expiring tomorrow and then selling it just before it expires, I don’t actually pay cash for the forward in one transaction and receive cash in a separate transaction when I sell it. Instead, the transaction gets netted out. If the currency has moved in my favor, I get paid a small amount of money; if it has moved against me, I pay a small amount of money. If it hasn’t moved at all, I get a tiny amount of money, corresponding to one day’s interest in local currency. Annualize that tiny amount of money, and you’re looking at the carry.

The investors, meanwhile, have put up an amount of money corresponding to the full notional amount of the underlying currency. That money needs to be invested somewhere, so it gets invested in T-bills. Hence the added T-bill interest rate. The T-bill interest rate isn’t large, but it’s the only actual interest paid on these instruments. The local-currency interest, by contrast, is basically an arbitrage condition: the forwards markets always reflect local interest rates because if they didn’t there would be a no-brainer arbitrage there. (This kind of arbitrage can fall apart during something as chaotic as the Icelandic devaluation, which was accompanied by the default of all the local Icelandic banks, but the currency ETCs invest only in G10 currencies, where that kind of thing hasn’t ever happened. Yet.)

The ETCs are dollar-denominated, and they all include either a long-dollar or a short-dollar position. The two facts cancel each other out, so if you’re a UK or euro investor who buys say the long Aussie-dollar ETC, you’re essentially getting direct exposure to the Aussie dollar in pounds or euros or whatever the currency is that you’re using to buy and sell the ETCs.

The ETCs are guaranteed to underperform their index, thanks to those 39bp in fees. But they shouldn’t underperform more than that, since Morgan Stanley has promised to pay the index return. “If Morgan Stanley didn’t pay us the index, they would be in default,” says Bienkowski. On top of that, much of the added complexity of the instruments is essentially designed to hedge precisely that Morgan Stanley counterparty risk.

Bienkowski is a fan of the instruments. “If you want to get access to foreign currency, I think these products are pretty good,” he says. “They aren’t leveraged, they’re not a CFD or a warrant. They’re basically bringing institutional money-market interest rates and spreads to the average investor. “

Thatsaid, currency ETCs are complex, and not easy to understand. There’s language in the prospectus about not buying them without talking to an independent financial advisor, but the fact is that most independent financial advisors aren’t going to be able to understand this prospectus very easily either. (Izabella Kaminska and I are at least as good at understanding these things as most independent financial advisors are, and we got very confused by them.)

If you’re a fan of the UK Financial Services Authority, you might take some solace in the fact that it has signed off on these currency ETCs; they fulfill its listing requirements as debt securities. “We’re bringing the wholesale currency market to a regulated exchange,” says Bienkowski. But the fact is that there’s still a lot of complexity here. In general it’s a good idea not to buy things you don’t understand, and there’s a lot of stuff in the prospectus which is difficult to understand.

On the other hand, historically it has been almost impossible for retail investors to play the carry trade, invest in foreign exchange, or in general diversify into fx as an asset class. If you’re worried that your investment currency is going to implode (be it dollars or pounds or anything else), then buying a few of these ETCs will give you some kind of hedge against that, helping to preserve international purchasing power. The underlying mechanics of them are not particularly pretty, but if you’re going to rely on the continued liquidity of any financial market in the world, the fx market is probably the best one to rely on: it’s incredibly liquid and robust.

Currency ETCs are very new and untested things, and so a sensible investor will probably hold off for a little while longer to see how they do. It might also be interesting to see whether and when a similar product might list on a US exchange. But in principle I can see why these things were invented, and I can also see why a certain class of globally-focused retail investor might be interested in buying them.


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Sorry playing catch up. I see you have a reply :-)Surely you’re still only reaping the overnight rate versus your cost to roll the position over from day to day at best?Except having checked the Bloomberg data I know where I went wrong, the spot rates are cheaper going forward not more expensive (commodity head on, where you obviously compensate for the cost of money. Here we’re dealing with money)– so you earn the interest, there is no cost.Nevertheless, you’re still missing out on investing in longer-dated paper, 4.8% return in the last 5 years compares to an average 5.3% per annum interest rates in the period.But definitely worth the clarification — i did warn everyone they were complicated!

Posted by Izabella Kaminska | Report as abusive

This is indeed quite complicated. But I’m not sure that technically, your commenter Daniel and you are saying the same thing. If you buy for Value date tom, and you sell at spot, you end up losing money on, say, an AUDUSD trade. For this to be profitable, you have to buy spot+1 (which is 3 days forward) and sell spot. Basically, if the interest rates are higher in Australia, the forward points will be negative for forward dates, but they will be positive for value dates of less than spot, i.e. today or tomorrow.A couple more points:There can be important disruptions in the swap/forward market in the G10 currencies as well. It happened last year, when banks were freaking out about counterparty risk after Lehman fell.Retail investors can in fact play the carry trade, or play foreign exchange, via structured notes. There are tons of them that can be designed, through options, to do whatever investors want. The problem here is the issue of transparency, as investors will most likely not understand the underlying option structure. And of course, counterparty risk will still exist.

Posted by jg | Report as abusive

@jg — So much for second guessing myself. I am going to do some intensive reading on this subject matter this week methinks.

Posted by Izabella Kaminska | Report as abusive

Here’s how this works (ignoring the bid/ask spread, which is a non-trivial 3 pips wide):Looking at my Bloomberg screen (FRD), AUDUSD is currently trading .9285 @ .9288 (let’s call it .9286) with 1 day points of -0.87 @ -0.80 (let’s call them -0.85). The points are not based on just Australian rates; they are based on the difference between US rates and Australian rates.Here’s a long Aussie trade:Buy the index for settle in Spot + 1; this will cost the spot offer (simplified to .9286) + forward points (-.85) for an all-in rate of .928515 ($10,000 US will net you 10,769.89 Aussies).Let’s assume no change in the spot rate or interest rate differentials, just time decay from today until tomorrow.Sell the index for settle in spot; this will cost the spot bid (.9286) and your 10,769.89 Aussies net $10,000.92 US. That $.92 per $10,000 is your 1-day carry. If you earn $.92 per day every day (ignoring compounding), you’ll make $335.80 (which seems reasonable given 3M Australian Sovereign yields at 3.5%) before you pay $39 to the ETC in fees. Now, this obviously ignores that when you have to cross the bid/ask each day, Morgan Stanley is going to take your money, so you still need currency appreciation to make any money, but that’s how carry works with minimal transaction costs.

Posted by Mitch | Report as abusive

It’s amusing how little financial bloggers seem to know about what they’re blogging about :)There’s nothing particularly complicated about how this works, it’s pretty much how every commodity index and ETF works, for example, except those roll as less frequent intervals than daily, because of the nature of that market.Iza, it’s not “obvious” that commodity markets are in contango, it’s the same principle there, it depends on whether the convenience yield of the commodity is higher than the cost of money in the funding currency or not.The whole point of the currency “carry trade”, is that there is a benefit rolling a long AUD/short USD position forward, so it’s hard to see how someone would get confused into thinking its a cost..Mitch, good explanation, just one point I would add on the bid/ask for clarity, once the units have been issued and the initial position has been put on, the day on day roll incurs a much smaller transaction cost than the initial position. The larger bid/ask would again be paid upon unwinding the position and redeeming units. So there’s a maybe 3bp total cost involved in entering/exiting, and then a small daily cost for rolling. The 3bp cost is paid by Morgan Stanley (and is presumably recovered by them as part of the 39bp the investor is paying).

Posted by nivedita | Report as abusive

Well, it took some courage to use that “almost impossible” link to your own 2007 posting. Shorting yen would have worked out real well (not!) for a retail investor (03/21/07: 117.59; today: 86.38), not to mention the absolutely priceless quote about “a much lower-risk investment like an AAA-rated tranche of a CDO”.

Posted by anonymous | Report as abusive