Case Study, Diego: Four Quiet Months and One Loud One

[Fairman]

Case Study, Diego: Four Quiet Months and One Loud One

Diego is a composite character. He runs a carry trade, long a high-yielding currency against a low-yielding one, with a 10,000-dollar position size relative to a 20,000-dollar account. The pair paid positive swap, and his account grew 0.6 percent a month for four months. In the fifth month, a risk-off shock cut the pair by 9 percent in a week.

Compute the effect. Four months at plus 0.6 percent: 1.006 to the 4th power is 1.0242, so the account reached about 20,484 dollars. A 9 percent fall on a 10,000-dollar position is 900 dollars, a 4.4 percent loss on the account at that point. The account fell to about 19,584.

Net after five months: 19,584 against 20,000, minus 2.1 percent. Four months of carry were erased by one week.

How should he have thought about it? The carry earned 120 dollars a month on 20,000, while the position's monthly volatility was perhaps 3 percent of 10,000, which is 300 dollars. He was collecting a small, steady premium for bearing a risk several times larger.

What if the position had been 20,000 dollars, matching the account, with the same percentage drop? The loss would be 1,800 dollars, 9 percent. Carry would be 240 a month.

What protects you? Smaller size, a stop loss, a volatility filter that exits when risk-off signals appear, and diversification across pairs. The first of these matters most.

Lesson: the smoother the income, the more carefully you should study the tail.

Exercise: compute the ratio of monthly carry to a one-standard-deviation monthly move for any carry position you consider.