Volatile Turkish Lira Position? Hedge it with the Hungarian Forint

Jan. 1.08 | About: iPath GBP/USD (GBB)

Almost daily, I receive emails asking how traders, drawn to the high interest rate feature of the currency, can profit from the Turkish Lira. It is easy to forget about the huge volatile moves that has plagued the currency since its re-release. To look for a safe hedge currency, I examined the available currencies of surrounding countries with economies in the same development phase. The logical choice would have been a bordering country, but since there are few choices that offer enough liquidity, the closest match was Hungary.

Examining the following calculations of volatility and correlation, you can see the two currencies appear to provide the necessary hedge that will allow traders to profit and at the same time sleep comfortably at night.

The correlation between the two pairs EUR/TRY and EUR/HUF was .87591 during the three-month period of August 1, 2007 to October 31, 2007. This is a significant positive correlation because the market was extremely volatile during the August carry trade unwinding. The fact that the two pairs exhibit a strong, positive correlation means that a trader can go short the EUR/TRY and long the EUR/HUF, and the movement of the two currency pairs, which hopefully will continue exhibiting a strong correlation, will move inversely.

The historic volatility is also significantly lowered when the hedge is in place. Over the volatile August carry trade unwind period, the TRY/HUF pair had an annual volatility calculation of 16.6552%, while the USD/TRY pair had a calculated annual volatility of 25.2925%. While not all times are as volatile as was experienced in August, looking at the August and September period combined, the volatility is still lower in the TRY/HUF pair than the USD/TRY pair, at 13.5576% and 17.6828% respectively.

There is a trade-off to hedging the Turkish Lira with the Hungarian Forint and that is the amount of interest paid on the hedge. With a long Turkish Lira, an investor is receiving 15.75% in interest per year, while with a short position in the Hungarian Forint will cost an investor 8% in interest payments per year, netting the investor a positive 7.75% interest rate spread.

The lower interest received from placing this hedge may not be to the liking of some investors, but the fact remains that the pair will be less affected by a potential carry trade unwind. It appears that the Turkish Lira at this time is ready for a short, sharp depreciation versus the Euro and US Dollar, as it has been treading water over the past three months. However, other emerging currencies can match up with the Turkish Lira and provide a decent hedge, but none can match the Hungarian Forint in terms of similar economic conditions, strong correlation, and an excellent positive interest rate spread.

Disclosure: The author currently holds a synthetic long TRY/HUF position (short EUR/TRY, long EUR/HUF)