Stepping back from the ETC confusion

November 17, 2009 in Economics,Finance

Following the lead of an FT article last week, FT Alphaville went exploring ETC's (exchange traded currencies) and noted (emphasis mine):

As for the investor... it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then).

The bold phrase prompted Felix Salmon to wonder how an ETC could "provide exposure to local interest rates" (as stated in the original article), when the follow-up claims there's no interest at all? Felix tracked through various prospecti and documents in search of an answer, but couldn't get a clear description of the ETC's exposure. The closest he came was this, from Morgan Stanley Foreign Exchange (MSFX) indices documentation:

For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily at the One-Month T-Bill Rate… Hence, the daily return on the related MSFX Total Return Index will be computed as the sum of the MSFX Currency return and the One-Month T-Bill return.

To which Felix notes:

There certainly doesn’t seem to be any mention of local interest rates there.

And so both Felix and FT Alphaville concluded that despite having currency exposure, these securities can not replicate the carry trade. But this morning, Felix posted that ETC's do in fact have sensitivity to local interest rates and, by extention, the carry trade.

I'm a bit surprised that this has taken so many words and posts to resolve. I think everyone needs to step back and review the basic mechanics of these products rather than go chasing details Here are a few key definitions:

  1. Total return: the return received on an investment, if all distributions (dividends and interest) were reinvested.
  2. Interest rate parity: a theory which equates exchange rates and interest rates. The forward exchange rate is given by the spot exchange rate times the ratio of the two currencies' interest rates. This model can decompose all FX moves into interest rate moves, and vice versa.

FT Alphaville was correct that the ETC's do not pay any interest or dividends. However, because they are total return indices, they were incorrect that this eliminates the carry trade.

Felix was correct that the documentation made no mention of local interest rates, but that's a technicality as he failed to appreciate that interest rates and exchange rates are two sides of the same coin, particularly because total return indices were used in the absence of distributing interest payments.

When you borrow yen to lend dollars, you are earning a dollar interest rate and paying a yen rate; the differential (according to interest rate parity) corresponds to the exchange rate and would normally erase itself if the BoJ didn't keep rates so low. Thus, the return on that yen trade corresponds to the difference between local and domestic interest rates. Finally, adding the T-Bill return on top of the exchange rate return means that the ETC is equivalent to investing in the currencies themselves, interest payments and all. And that's it.

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