Gadzooks! Which is the safest of them all? Clearly Swiss Francs…

This is one of those moments most currency traders and macro hedge funds feel REALLY sheepish/scared:

That'll hurt.  Source: thinkorswim by TDAmeritrade.

That’ll hurt: Swiss Franc futures reverse mightily. Source: thinkorswim by TDAmeritrade.

Imagine the situation:

  1. Beginning: the Swiss Franc seems a safe play.  Very carefully managed by the Swiss National Bank (SNB), which REALLY doesn’t want much variation in their safe-haven currency, you assume a stable relationship.
  2. The initial trade: Swiss interest rates are very low – in fact, negative.  This sets up the proverbial carry trade – borrow in Swiss francs to fund a bet in any currency.  Let’s just use the USD, as it has a terrible low interest rate too, but is still pretty safe.  So you pick up 50bps (around 0.25% in the US, set against -0.25% in Switzerland) in a pretty safe pair.
  3. Life is good: this interest rate differential is picked up in the futures through the near-continuous downward trend we see in the chart above.  Ahh, relax and go short this futures contract.
  4. Today: Oh Shit.  The SNB decides enough is enough, and stops putting a floor on its safe-haven currency.  Interest rates move to -0.75%, so your carry signal says stay short the contract.  But the underlying moves about 30% against you, negating about 60 years worth of the old carry returns.  Oh dear.  Hopefully you didn’t cash out at the worst point, as the pair has only moved about 15% at this point.
  5. Statistics?!? Who cares?  The implied volatility of the future has been around 10% p.a., or around 0.7% daily.  So a 30% daily move is about…45 standard deviations.  We’re talking infinitesimal probabilities.
  6. When writing uncovered calls really sucks.  God forbid you had a system of writing calls to collect the carry here.  Suppose you wrote a $1 call on the contract above yesterday, giving yourself a bit of room on yesterday’s $0.987 close to collect the carry.  Your premium? About $.005 for a 30-day option, which is now MTM at about $0.124 (essentially delta=1 here, so whatever the difference between $1 and the current market price).  Your loss is about $0.12 per contract, or $15,000.  So you collected $625 in premium to now need to post $15,000.  Ouch.

In sum: I’m sure we will find out about certain funds which collapse from this type of trade, or those who trade against consensus and made a ton.  I am very happy not to have been playing this currency.  For option traders – this is the reason you use defined risk trades: yes, you give up a fraction on every trade you do, but it can save your bacon when things like this happen.


Leverage for young folks

Reading Rational Expectations, I came across one really interesting portfolio management idea for life-cycle investing: leverage holdings at a young age.

This follows from research by Nalebuff-Ayres which runs a bit like:

  1. A young person generally begins her career with a lot of human capital (future earnings power) and near-zero financial capital (actual savings).
  2. The young person saves regularly towards retirement.  How should she invest her savings?
  3. With maximum human capital and minimal financial capital, the ‘right’ thing to do is leverage what financial capital is available, buying stocks on margin or using index option strategies.
  4. As the person ages, the leverage comes down, until it goes away in her 40s/50s.

I like this idea: buy stock index options as a youngster, so one can make a leveraged stock investment when one’s risk tolerance is highest.  Using options rather than margin loans means the maximum loss is limited to the amount paid for the options – you’ll never be called by the brokerage to put up more funds.  I’d further offset the implied interest rate on the index options (the extrinsic, or time, value of the option) by selling out of the money nearer-term options.  Oh wait, that’s what I’m doing!!