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What is a Franken-Bull? It’s a term I came up for a market that has bearish fundamentals, but experiencing a bull run. Robin Wigglesworth, “Jane Street: The Top Wall Street Firm ‘No One’s Heard Of,’” Financial Times, January 28, 2021. Simply put, carry trading is now the primary determinant of the global business cycle - a pattern of long, steady but unspectacular expansions punctuated by catastrophic crises. What effect does a short volatility trader have on the market? The authors are not explicit here, but a simple thought experiment may help. Consider first the delta hedging trader. If the market rises, they are forced to buy. If it falls, they must sell. Their actions will increase market volatility. Interestingly, if they have sold their option to another delta hedged trader, then their actions will be exactly mirrored by the buyer. There is zero net effect on the market, since their trades will exactly offset (assuming the same hedging strategy is used).
Now, if you believe everything that was previously said, and thereby having established a coherent link between carry trades and the dual prongs of the fed, you come to some sobering realizations; namely: If you think easing and tightening at the same time sounds like a contradiction, sounds like a loss of control, I’m with you. But, as the authors point out, carry trading is not limited to rogue traders. Collecting steady premia is what an insurance company does. Banks, who borrow and lend to earn an interest rate spread, are also carry trading. But insurers and banks diversify across many customers, transforming a portfolio of risky bets into a benign balance sheet. In contrast, most carry trades in the financial markets are correlated in market crashes, so true diversification is hard to find. The book only briefly mentions the accumulation of moral hazard. However, in my opinion, this is where the main problem lies. In the institutions that run the society, the proportion of idiots has been steadily increasing for many decades. It is now close to 100%. These characteristics are reflected in the options market on which the VIX is based. As both put and call options provide the same cover against market volatility, the prices of the two exhibit a phenomenon known as “put-call parity,” diverging little from each other.He is a co-author of The Rise of Carry (2020). He is also the author of the highly regarded Economics for Professional Investors (2nd edition 1998) along with many articles in newspapers and journals. His commentaries and analyses have been widely quoted. The more ambitious parts of the book are those that discuss carry as a wider phenomenon that affects large parts of the economy; from international trade to domestic macroeconomics, and even as a possible cause of economic inequality. The section on international financial flows is both original and interesting. But this may be less relevant if the US dollar is no longer the go-to currency for financing carry trades. Volatility suppression happens in both the currency markets as well as other equities (in today's age they are very highly correlated) and allows for the use of extreme 'carry' as an investing strategy.
Tim Lee is the founder of the independent economics consultancy pi Economics, serving financial institutions from hedge funds to traditional asset managers. Prior to setting up pi Economics in Greenwich, Connecticut, in 2003, he worked in London as European economist and global economic strategist for asset management companies including GT Management and Invesco. Before London, he spent nine years in Hong Kong as an Asian economist for GT Management.
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The central thesis of the book is as follows. The financial authorities of developed countries artificially suppress volatility in financial markets. In the past few decades, selling volatility has been too profitable. The buyers of put option made significant profits in those rare periods when the bubbles collapsed. However, even despite it, buying volatility has been too unprofitable.
The Rise of Carry’ is the best book on the topic of ‘Carry’ I came across so far. It is excellently written, well-structured, well-researched, and thought provoking. Being a practitioner in the asset management industry who have witnessed the recent rise and crash of carry first-hand, lots of the concepts and insights in this book feel close to my heart. I sincerely recommend this book to fellow readers. In my own career I’ve come across it many times. As an inexperienced investment bank trader I was admonished by a senior trader for being ‘short naked gamma’: selling options in the market without the safety net of delta hedging, an especially dangerous variation of the carry trade. A few years later in 2008 I was managing a hedge fund carry strategy which lost a third of it’s notional capital in a matter of weeks. Thankfully, we had reduced it’s risk allocation for unrelated reasons, saving our clients hundreds of millions of dollars. I still trade carry today, although only as a minor component in a diversified portfolio of strategies.But the intuition behind the indicator is that what matters is the present rate of money growth…I think it would be hard to get an inflationary result out of the present conjunction of any possible relevant variables.”
He currently lives in Oakland, California with his wife Jody and their four children and has as a moderate-to-severe obsession with tennis. Protect yourself from the next financial meltdown with this game-changing primer on financial markets, the economy—and the meteoric rise of carry.Jamie Lee works for investment guru and philanthropist Jeremy Grantham, focusing on environmental research and volatility trading. He previously worked as economist and analyst for asset management companies in Boston and London. Jamie holds a B.A. in Mathematics and English from Dartmouth College.
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