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BNP Paribas Launches Indices to Combat Carry Trades

BNP Paribas has launched two investable indices that protect investors from the effects of a global unwinding of carry trades. The Galaxy Alpha and Galaxy Alpha Plus indices are both designed to offer investors an alternative to traditional carry trade strategies.

The carry trade – which exploits the interest rate differential between currencies – has historically been a very popular strategy for investors, but during the current credit crisis, extreme volatility in FX and interest rate markets have resulted in carry trade indices underperforming.

The Galaxy Alpha indices seek to extract the outperformance between a dynamic basket, which is selected every month based on the currencies with the highest interest rate differentials, and a fixed benchmark basket of traditional carry pairs. This makes it possible for the indices to perform well even during periods of carry unwind, the bank says.

An algorithm selects carry pairs with the widest interest rate differentials and uses a mechanism to identify and eliminate the currencies that have exhibited behaviour that is normally indicative of carry unwinds over the past month. The benchmark carry basket is then subtracted from the high interest currency basket to give the return.

“What makes our Alpha indices unique is the inclusion of a benchmark carry index,” says Kara Lemont, European head of interest rate and foreign exchange structuring. “Whereas traditional carry trade indices optimise the selection of currency pairs, and some others can go long or short individual currencies within a basket, the Alpha indices are the first to be specifically designed to extract the outperformance of the selected pairs versus a traditional carry basket. This gives investors more flexibility than ever before.”

As of Friday (21 November), the historical annual excess return (over the risk free rate) was 9.39% for the Alpha index and 10.77% for the Alpha Plus index, from January 1999. The Sharpe Ratio of the Alpha index was 1.77 and of the Alpha Plus was 1.88.

The Alpha index is a market neutral carry index. It scales the static basket in order to have the same allocation in the dynamic basket and the benchmark. The Alpha Plus index can be long, neutral or short the carry trade depending on the strength of carry or carry unwinds prevalent in the market.

When carry trades are generally performing, the Alpha Plus index provides an extra return on top of the outperformance. In the periods when the carry unwind is anticipated, Alpha Plus provides a return by being short the typical carry currency pairs.

The fixed benchmark basket comprises four high yielders in TRY, ZAR, NZD and INR and four low yielders in CHF, JPY, SGD and EUR. The currency pairs in the dynamic basket are chosen every month from a basket of 24 currencies globally. These are the G10 currencies, together with INR, PHP, SGD, TWD, KRW, IDR in Asia; PLN, CZK, HUF, SKK, TRY in Eastern Europe; as well as ZAR, CLP, MXN and BRL.

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