With this in mind, carry trades represent significant risks for the recipient economies: if exchange rates move in the direction of devaluing host economy currency, there can be fast unwinding of the carry trades and capital outflow from the host economy.
Now, let’s define, per BIS, the Carry-to-Risk Ratio as “the attractiveness of carry trades” measured by “the …risk-adjusted profitability of a carry trade position [e.g. the one-month interest rate differential]… divided by the implied volatility of one-month at-the-money exchange rate options”. In simple terms, this ratio measures risk-adjusted returns to carry trades – the higher the ratio, the higher the implied risk-adjusted returns.
Here is a BIS chart mapping the risk-adjusted ratios for carry trades for six major carry trade targets:
Massive devaluation of the Russian Ruble means that carry trades into Russia (borrowing, say in low interest rate euros and buying Russian assets) have fallen off the cliff in terms of expected risk-adjusted returns. There are couple of things this chart suggests:
- Dramatically higher interest rates in Russia under the CBR policy are not enough to compensate for the decline in Ruble valuations;
- Forward expectations are consistent with two things: Ruble devaluing further and Russian interest rates declining from their current levels.