Lehman Brothers | Global FX Strategies

FOCUS

Optionalising carry trades

Anne Sanciaume Carry trades are the bread and butter of the FX investor. By borrowing low-yielding
+44 20 710 31301 currencies and investing in higher-yielding currencies, one may, on average, be able to
asanciau@lehman.com capture part of the interest rate differential without suffering offsetting losses on the FX spot
rate suggested by economic theory. In the past, we have looked at ways to optimise a forward
premium basket using cash instruments and relying on diversification and filtration by risk
indices to keep our risk down. In this new study, we look at the options market as another
way to invest in the forward premium. We find that options offer an interesting alternative to
implement forward bias strategies, especially in G10: simple vanilla calls on the high
yielders offer consistent positive returns, but RKOs offer yet an improved performance. For
EM, the picture is a little less clear-cut, perhaps because our choice of currency pairs was
driven more by data availability than by interest-rate differentials. Still options seem to offer
a viable alternative to trade the forward bias.

CARRY TRADES - BACKGROUND

Years of statistical analysis and practical experience have shown that forward rates are
biased predictors of future spot exchange rates. In essence, forward rates suggest that high
interest rate currencies should depreciate against low interest rate ones, while historical
experience proves the opposite. By and large, investors borrow in the low yielders (JPY,
CHF and, to a lesser extent, USD) and invest in high yielders (e.g., AUD, GBP, and EM
currencies) in a bid to capture the interest rate differential. This is known as carry trading.
Because carry trades are widespread in the market, the high-yielding currencies will
generally be in high demand and thus will tend to appreciate to the detriment of the low-
yielding currencies. The main caveat to this type of strategy is that in times of higher risk
aversion, money will tend to flush out of the more risky currencies (the high yielders) with
the funding currencies then enjoying sharp one-off appreciations. Over the years, Lehman
Brothers has proposed increasingly sophisticated approaches to maximise the
returns/minimise the risk of forward-premium portfolios using spot or forward transactions;
for instance, building optimal currency portfolios with mean variance optimisation, or
filtering extreme averseness through our Risk Premium Index.1
In this analysis we look at options as a possible tool for trading the forward bias. Indeed,
long option positions provide a way of limiting the potential downside to the premium paid
while potentially offering unlimited upside and consequently look well suited to the task.
We have used data between 1998 and the present in G10 and between 2001 and the present
in EM (given data availability). We are using 1-month option contracts to keep within the
scope of our previous work on forwards.2 Our choice of currency pairs was driven by
interest rate levels (typical low yielders like the JPY against typical high yielders) and by
data availability in emerging markets. We have opted to go long the typical higher yielder
(say ZAR) but to go flat when the differential in interest rates has flipped over. We look at
two subsets of currency pairs in this study: one for EM and one for G10. In EM, our choice
of currency pairs was guided by data availability. Any extension of the work presented here
would require a shorter history window. In G10, our choice of pairs was also partially guided

1
See Baz, Breedon, Naik, Peress: “Optimal Currency Portfolios: Trading on the Forward Bias”
See Ellis, Jiltsov Lehman Brother’s Forward Bias currency baskets
2
In this study we are using overlapping positions for options to multiply the number of available data points and have a
more detailed view of min/max returns. However, we have also performed this analysis using non-overlapping data
(trading only once a month) and obtained very similar returns and information ratios.
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES AT THE END OF THIS REPORT
Lehman Brothers | Global FX Strategies

by data availability: we did not have a sufficient sample in the Scandinavian currencies.
Where other pairs are concerned, we have selected the yen which had the lowest interest rate
over the period (Figure 1) as our main funding currency. Consequently, we are usually short
against the other pairs. We have also added EUR/USD to our selection to see whether
options on this major cross can be successfully traded using the forward bias (it was a poor
performer for the volatility risk premium). We have also thrown in USD/CHF because CHF
is one of the most common funding currencies and USD/CHF data are widely available. Our
global choice of currency pairs is thus somewhat arbitrary but offers a good cross section of
performance. We can tailor portfolios to suit investors’ requirements upon request.

Figure 1. 1-month Deposit rates over our sample in G10

0
JPY CHF EUR SEK USD CAD NOK GBP AUD

Source: Lehman Brothers

In the G10 space, forward bias strategy returns depend on the funding currency used, but
usually provide encouraging information ratios without filtration – on the order of 0.60 if
JPY is the funding currency, above 1 when USD is used for funding. There is little point
setting a comparison point for EM carry baskets as we have not enough volatility data to
back-test the EM currencies most commonly used in spot-based carry baskets (e.g., TRY).

CALLS/PUTS
The simplest way to capture the forward bias through options is through systematic use of
vanilla calls on the high-yielding currency/puts on the low-yielding currency. For a start,
going long the options will provide adequate exposure and possible unlimited upside. In this
study, we have simulated going long at-the-money forward options, which lets us capture the
interest rate differential. As long as spot does not depreciate by more than is anticipated by
economic theory, the option will expire in the money. Moreover, if the high-yielding
currency appreciates on high demand, the option may end up in profit. Conversely, if risk
aversion strikes and investors flush out of carry trades, the option buyer will lose only his
premium, potentially less than would have been lost on a systematic spot or forward strategy.

G10
The plain puts on the low-yielders work well in G10: returns are positive for all currency pairs
(inclusive of a 6bp bid/offer spread). Information ratios range from 0.05 in USD/CHF to 0.41
in EUR/USD (Figure 2). The portfolio achieves an average annualised return near 2%, with an
information ratio of 0.50. The skew of the distribution of our returns is to the upside, a feature

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not often found in option strategies. Although the options positions overlap here, we
conducted a similar analysis for non-overlapping positions, with very similar results.

Figure 2. Trading the forward bias through calls/puts in G10, inc. transaction costs

EUR/USD USD/JPY GBP/JPY USD/CHF AUD/JPY CAD/JPY EUR/JPY portfolio

Av. Ann. PnL 1.93% 1.63% 2.86% 0.26% 2.90% 2.24% 2.03% 1.98%
Information Ratio 0.41 0.25 0.40 0.05 0.40 0.33 0.27 0.47
skew 1.56 1.14 1.45 1.02 1.20 1.09 1.87 1.03
max 6.81% 8.23% 8.94% 5.77% 9.39% 7.62% 13.44% 5.50%
percentile 90 2.09% 2.94% 3.17% 2.57% 3.19% 3.20% 2.96% 1.82%
percentile 10 -1.21% -1.52% -1.58% -1.35% -1.71% -1.56% -1.71% -1.08%
min -1.98% -3.17% -2.94% -1.94% -2.94% -1.64% -4.32% -2.02%
Source: Lehman Brothers

EM
The plain puts on the low yielders do not work as well in EM pairs as it does for G10 (Figure
3). This is mostly because of USD/MXN, which does not achieve positive returns, although
all other pairs do. The discrepancies in performance can probably be explained at least in part
by our choice of currency pairs, which for emerging markets was driven more by data
availability than interest rate differentials. The portfolio achieves an annualised return of
1.34% (using offer data on volatility) with an information ratio of 0.52, similar to G10.

Figure 3. Trading the forward bias through calls/puts in EM, inc. transaction costs

USD/MXN EUR/PLN EUR/CZK USD/ZAR USD/ILS USD/THB portfolio

Av. Ann. PnL -0.96% 1.48% 0.92% 5.40% 1.07% 0.12% 1.34%
Information Ratio -0.22 0.27 0.34 0.53 0.25 0.05 0.52
skew 0.98 0.76 2.11 0.97 1.47 1.78 0.63
max 5.56% 5.57% 4.33% 10.33% 6.34% 4.28% 3.30%
percentile 90 1.68% 2.44% 0.89% 4.94% 1.92% 0.98% 1.08%
percentile 10 -1.30% -1.35% -0.73% -2.37% -1.03% -0.77% -0.79%
Min -1.60% -2.69% -1.74% -4.08% -1.57% -1.38% -1.31%
Source: Lehman Brothers

While the forward bias options strategies do not offer particularly high returns, they do offer
some interesting characteristics: they are long options strategies that are profitable on a
systematic basis (although this is mostly because of the directional component). The skew of
the distribution of returns is positive unlike for all the volatility risk premium strategies, for
instance. Along the same lines, the maximum returns achieved per trade outweigh the
maximum losses. Finally, while most volatility-risk-premium-based strategies have lost
momentum as market sellers became more numerous in recent years, the forward bias option
strategy has, if anything, gained momentum during the period as options have cheapened.

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Lehman Brothers | Global FX Strategies

Figure 4. Cumulative returns from trading the forward bias through calls/puts in G10
and EM

4.5

3.5 G10

2.5

2
EM
1.5

0.5

-0.5
18/07/97 18/01/99 18/07/00 18/01/02 18/07/03 18/01/05

Source: Lehman Brothers

While the simple call/put strategy offers promising results, the premium we pay for the
options may be a drag in the sense that we pay for volatility whereas our central scenario
relies on a limited appreciation of the high yielder. In the next sections, we look at ways to
reduce the premium amount paid.

CALL/PUT SPREADS
The easiest way to reduce our premium while still retaining some of the upside potential is
through the use of call spreads on the high-yielding currencies. True, our upside potential
will no longer be unlimited, but the forward bias strategy does not rely on sharp spot moves
(if anything, the opposite strategy would be a better candidate as low-yielders often enjoy
sharp one-off appreciations time of heightened risk aversion). However, the premium will
also be much reduced, implying less of an upfront investment to enter the position. We have
used an at-the-money vs 25delta strike combination of our call/put spreads, using a smile
interpolation to obtain our strike/volatility combination.

G10
In G10, entering call spreads on the high yielders provides an overall small improvement on
the information ratio compared to the outright calls, but this comes at the expense of some of
the returns. Currency by currency basis, the only real improvement occurs in USD/CHF, with
returns going up to 1.29% from 0.26% and the information ratio to 0.38 from 0.05 (Figure 5).

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Lehman Brothers | Global FX Strategies

Figure 5. Trading the forward bias through calls/put spreads in G10, inc. transaction
costs

EUR/USD USD/JPY GBP/JPY USD/CHF AUD/JPY CAD/JPY EUR/JPY Portfolio

Av. Ann. PnL 1.88% 1.34% 0.97% 1.29% 2.03% 1.86% 0.76% 1.21%
Information Ratio 0.78 0.38 0.30 0.38 0.52 0.50 0.22 0.61
skew 0.52 0.39 0.34 0.36 0.31 0.25 0.37 0.37
max 1.99% 3.38% 2.50% 2.10% 4.14% 2.03% 2.49% 1.87%
percentile 90 1.23% 1.54% 1.38% 1.43% 1.74% 1.61% 1.39% 0.91%
percentile 10 -0.68% -0.97% -0.92% -0.85% -1.06% -0.99% -1.05% -0.60%
min -1.20% -1.97% -1.62% -1.21% -1.83% -1.07% -1.70% -1.13%

Source: Lehman Brothers

EM
In EM, there is no improvement on an aggregate basis, either in terms of returns or
information ratio (Figure 6).

Figure 6. Trading the forward bias through calls/put spreads in EM, theoretical value

USD/MXN EUR/PLN EUR/CZK USD/ZAR USD/ILS USD/THB Portfolio

Av. Ann. PnL -0.03% 1.25% 0.43% 2.28% -0.11% -0.04% 0.63%
Information Ratio -0.01 0.40 0.34 0.45 -0.06 -0.03 0.49
skew 0.24 0.13 0.15 0.12 0.39 0.27 0.05
max 1.47% 1.72% 1.26% 3.27% 1.30% 1.51% 0.91%
percentile 90 0.98% 1.26% 0.61% 2.07% 0.86% 0.55% 0.55%
percentile 10 -0.85% -0.87% -0.47% -1.52% -0.67% -0.49% -0.44%
Min -1.07% -1.78% -1.14% -2.97% -1.04% -0.87% -0.81%
Source: Lehman Brothers

Consequently, call and put spreads do not appear to be a very attractive way to extract the
forward bias premium.

REVERSE KNOCK-OUT CALLS/PUTS

Reverse knock-out calls and puts offer a more sophisticated approach to investing in the
forward bias. The strike selection here remains at-the-money forward, while the barrier is
selected at 5% from the spot. The mechanics of these options are simple; let us consider
USD/JPY as an example, using a 1-month up-and-out call to play the carry. Let us imagine a
spot reference at 116.5, an ATF strike at 116.00 and a barrier at 122.50. The option starts its
life with a forward bias induced advantage: the spot is trading beyond the strike. If, during
the 1-month life of the option, spot never trades above 122.50, the option will have the same
payout as the plain vanilla call on USD. If, however, spot ever trades at or above 122.50
during the life of the option, the option ceases to exist. Consequently, this type of option will
benefit from an orderly and limited appreciation in the high-yielding currency, a likely
scenario when trying to capture the forward bias.
The main problem that we encountered as far as simulating systematic buying is concerned is
that reverse knock-out options do not trade at TV and that the actual price depends on the
volatility surface in particular with the adjustments not being linear. For G10 we have
arbitrarily set the offer price to be 5bp above TV which seems reasonable on average for the
pairs and sample used though it can not be used as a rule of thumb for punctual pricing. For
emerging markets, however, trying to apply any type of spread makes no sense because of
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Lehman Brothers | Global FX Strategies

the disparity in volatility levels and skew for the various currency pairs. Consequently, we
have used only TV for those pairs, on the view that the average returns can still give an idea
of whether they can represent good value based on today’s TV to actual price relationship.

G10
For G10, the RKO strategy performs best, with average annualised returns in excess of 2%
and an information ratio near 1. As with other strategies, distribution of returns is positively
skewed and maximum returns far outweigh minimum returns. AUD/JPY and CAD/JPY
appear the best performers, with returns above 3%, while GBP/JPY lags, with returns just
below 2%. We find the consistency of performance across currency pairs remarkable.

Figure 7. Trading the forward bias through RKOs in G10, inc. transaction costs

EUR/USD USD/JPY GBP/JPY USD/CHF AUD/JPY CAD/JPY EUR/JPY Portfolio

Av. Ann. PnL 2.37% 2.58% 1.83% 2.73% 3.20% 3.42% 2.00% 2.37%
Information Ratio 0.67 0.52 0.40 0.57 0.64 0.68 0.43 0.95
skew 1.70 1.23 1.33 1.14 1.22 1.18 1.35 0.68
max 4.24% 4.74% 5.13% 4.60% 5.15% 4.67% 4.79% 2.69%
percentile 90 1.81% 2.66% 2.30% 2.53% 2.74% 2.76% 2.32% 1.27%
percentile 10 -0.84% -0.86% -0.88% -0.86% -0.87% -0.86% -0.86% -0.68%
min -0.87% -0.90% -0.90% -0.88% -0.90% -0.88% -0.88% -0.87%

Source: Lehman Brothers

EM
In EM, the RKO appears to outperform other strategies at first sight but transaction costs are
not included here: they would be likely to erode returns significantly. Here the performance
is less consistent between currency pairs though the returns are positive everywhere. The best
performer by far is EUR/PLN with annualised returns in excess of 6%.

Figure 8. Trading the forward bias through RKOs in EM, inc. transaction costs

USD/MXN EUR/PLN EUR/CZK USD/ZAR USD/ILS USD/THB Portfolio

Av. Ann. PnL 2.30% 6.11% 0.49% 0.84% 1.76% 1.06% 2.09%
Information Ratio 0.57 1.20 0.24 0.21 0.45 0.40 1.17
Skew 1.01 0.82 1.84 2.04 1.34 1.89 0.66
Max 4.01% 4.84% 3.67% 5.08% 4.34% 3.78% 2.01%
percentile 90 1.97% 2.77% 0.80% 2.02% 1.94% 1.12% 0.91%
percentile 10 -0.81% -0.80% -0.67% -0.67% -0.79% -0.67% -0.44%
Min -0.90% -0.90% -0.77% -0.84% -0.86% -0.88% -0.75%

Source: Lehman Brothers

All in all, reverse knock-outs look like an attractive strategy to extract the forward bias
premium, especially in G10. Indeed, these options do not suffer too much from the volatility
risk premium effect as the barrier contributes to bringing the premium down. Furthermore,
these instruments are well suited to the incremental appreciation of the high yielders that the
forward bias strategies rely upon.

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Lehman Brothers | Global FX Strategies

Figure 4. Cumulative returns from trading the forward bias through RKOs in G10 and
EM

4.5

3.5 G10

2.5

2
EM
1.5

0.5

-0.5
31/12/98 31/12/99 31/12/00 31/12/01 31/12/02 31/12/03 31/12/04 31/12/05

Source: Lehman Brothers

CONCLUSION
We have shown that options strategies can be used to capture the currency forward bias.
Plain vanilla strategies – buying calls on the high yielders – work well, with performance
further improved by the use of reverse knock-outs for G10.
In the more general context of systematic option strategies, our analysis turns up some
interesting results. Indeed, most systematic options strategies are based on the volatility risk
premium (the difference between implied and realised volatility) and are systematically short
options to capture this premium. Being short optionality, these strategies occasionally suffer
big one-off losses and the distribution of their returns is negatively skewed. Here, we show
that systematic long positions can be profitable when combined with a directional bias, with
the forward bias outweighing the volatility risk premium effect. In particular, the distribution
of returns is positively skewed, with maximum returns well in excess of the maximum losses.

28 July 2006 7
The views expressed in this report accurately reflect the personal views of Anne Sanciaume, the primary analyst responsible for this report, about
the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the
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