AUD/USD Carry Trade With a Hedge of USD/CAD

by: Sean Bellamy McNulty

It is said that there is no free lunch; it would be more accurate to say there is no risk free lunch. The AUD/USD carry trade hedged with a position on the USD/CAD is an opportunity to enjoy a meal on the central banks, although not risk free, at a current yield of approximately 3% plus the amount of leverage used on the position.

This yield opportunity has been available on a consistent basis since 2002, in large part due to China's emergence and Australia's resource based economy. During this time, Australia has enjoyed consistent GDP growth and seen its exports rise from $15,000,000 AUD/mnth to over $25,000,000 AUD/mnth, ensuring the Reserve Bank of Australia kept interest rates elevated. In the USA and Canada, rates have been far lower due to crises in 2001, 2008 and the U.S. fiscal crisis that is now coming to a head. Canada, with ~75% of its trade with the U.S., essentially mirrors the U.S. rate.

Below are charts showing the past 20 year of interbank rates and the difference between the two currency pairs with the consequent yields. Both are on an annual basis:

Interbank Rates
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(Click to enlarge)

The hedge of the USD/CAD reduces the yield on the trade, but provides the benefit of reducing volatility and negates the requirement to speculate on the long term direction. Over the past 3 years, and largely over the past 10 years, the AUD/USD to USD/CAD has been highly correlated. On the 10 year monthly chart below, you'll see that it has consistently been 0.95 since the beginning of 2008 (red line bottom chart):

(Click to enlarge)

(Click to enlarge)

Therefore, by taking a position long AUD/USD hedged with the USD/CAD, a portfolio profits via the ~3% interbank rate while not losing capital in the rare instances the USD rallies.

Three percent is nothing to get excited about, and the yield will change depending on what you can borrow USD at. This is where leverage comes in. The FOREX market is renowned for its leveraging capabilities, much to the chagrin of legislators, who are now working on curbing the amount of margin available to retail FOREX investors. In my portfolio, I have the ability to margin my holdings 40 to 1, thus every $1 enables me to trade $40. This varies greatly based on who your FOREX broker is; I've seen rates advertised up to 500 to 1.

The amount to leverage to utilize depends on your personal risk tolerance and margin requirements. It's demonstrably not 500 to 1, but I'd advocate it's greater than 1 to 1. As a guide, below is a chart based on a $100,000 AUD/USD hedged with $100,000 USD/CAD with different rates of leverage and consequently different yields on an annual basis. Keep in mind; it's critical to leave enough room within your margin requirements for the inevitable short term deviations from the long term correlation between the two pairs.

(Click to enlarge)

Many retail investors seeking cashflow not experienced in the FOREX market may ponder the use of the carry trade when they could buy a blue chip equity stock and earn a single digit yield or a more speculative equity stock and earn a double digit yield. The answer is diversification, as it has been aptly demonstrated that the beta of securities goes to 1 in a crisis.

For a case and point, I backtested the volatile year of 2008. While equities lost 50% of their value and dividends were slashed, the 2 to 1 leveraged $100,000 AUD/USD hedged with $100,000 USD/CAD would have yielded ~6% and actually been up $7,890.

This example demonstrates the benefits of adding FOREX positions to your portfolio. Given that the FOREX market is relatively new, I believe there is much opportunity to explore how further additions such as this can raise the efficiency frontier as well as protect investors from black swan events. A hedged carry trade, or even a directional FOREX trade, is an underutilized element of modern day retail portfolios and an excellent addition for those seeking alpha.

Disclosure: I had a long position in AUD/USD from April 18th to May 3rd. I am currently long USD/CAD.