Documente Academic
Documente Profesional
Documente Cultură
I, Andreas Meixner
declare,
1. that I composed my Masters Thesis independently, have not used other
references than stipulated and have not used any illegitimate support
2. that I have not presented my Masters Thesis in any form or part of an exam
neither domestically nor abroad
Submitted by
Andreas Meixner
1. Advisor:
Univ.Prof. DDr. Jrgen Huber
2. Advisor:
Helga Wannerer, MA
Graham 1963: p. 65
-I
Abstract (English)
This paper investigates the role and performance of foreign currency borrowing to
Austrian private households. A large share of them used Swiss franc and Japanese
yen loans which are mostly constructed as balloon loans plus repayment vehicle as
substitute for conventional domestic currency borrowing. However, if uncovered
interest rate parity holds, interest rate differentials are expected to get offset by
exchange rate movements. The performance has been assessed according to
academic literature on currency carry trading via quarterly payoffs between 1990 and
2011. Balloon loan returns have been calculated by using the MSCI World index as
reference product for the repayment vehicle. General results are mean returns of
almost zero, unattractive Sharpe ratios and abysmal minimum returns for foreign
currency loans. Furthermore, costs and taxes related to the investigated balloon loan
construction lead to a substantial decrease of wealth.
Abstract (Deutsch)
Die
vorliegende
Arbeit
untersucht
die
Rolle
und
Rentabilitt
von
- II
Preface
Writing about a comprehensive topic which attaches a broad field of subjects in
finance like this is dependent on the support of many people.
In addition, meeting different people from all over the world and getting insights into
their broad range of professional experiences has been very beneficial in enhancing
my personal horizon.
My parents, Christa and Franz Meixner, and my brother, Thomas Meixner, who
always believed in my capabilities, encouraged me throughout this studying program.
Therefore they deserve my deepest gratitude.
- III
Index of Contents
Abstract (English) ....................................................................................................... II
Abstract (Deutsch) ...................................................................................................... II
Preface ...................................................................................................................... III
Index of Contents ...................................................................................................... IV
Index of Illustrations .................................................................................................. VII
Index of Equations ..................................................................................................... XI
List of Abbreviations ................................................................................................. XII
Executive Summary ................................................................................................. XIV
1
Introduction.......................................................................................................... 1
2.2
2.3
2.4
2.5
2.6
2.7
2.7.1
2.7.2
2.7.3
2.8
3
3.2
3.2.1
3.2.2
3.2.3
3.3
3.4
3.4.1
3.4.2
3.5
3.5.1
3.5.2
3.5.3
3.5.4
3.5.5
3.5.6
4.2
4.3
4.4
4.5
4.5.1
4.5.2
Quarterly Returns.................................................................................. 48
4.5.3
4.5.4
Annualized Returns............................................................................... 55
4.6
4.6.1
4.6.2
4.6.3
5.2
5.3
5.4
5.4.1
5.4.2
5.4.3
5.5
5.5.1
5.5.2
Bond Market.......................................................................................... 77
5.5.3
5.6
5.6.1
5.6.2
5.6.3
6.2
6.3
7.2
7.3
- VI
Index of Illustrations
Figure 1: Share of foreign currency loans of total private household loans
(Q1 1987 Q2 2011)................................................................................................... 4
Figure 2: Currency distribution of Austrian foreign currency private
household debt (Q4 2002 Q2 2011) ......................................................................... 5
Figure 3: Repayment structure of Austrian private household debt (Q2
2011) ........................................................................................................................... 6
Figure 4: Balloon loans with repayment vehicle per currency (Q2 2011) ..................... 6
Figure 5: Residual time to maturity of balloon loans with repayment vehicle
(Q2 2011) .................................................................................................................... 7
Figure 6: Austrian share of private household debt within the European
Monetary Union (Q2 1994 Q2 2011) ........................................................................ 8
Figure 7: Share of foreign currency debt of total private household debt
(Q2 1994 Q2 2011)................................................................................................... 8
Figure 8: Not harmonized retail bank interest rates for housing loans to
private households (Q2 1995 Q2 2003) .................................................................. 11
Figure 9: EUR/CHF (daily averages 01.01.1990 11.11.2011; prior 1999
ATS is converted by 13.7603 per EUR) ..................................................................... 17
Figure 10: 3 month LIBOR CHF and interest rate differential between 3
month EURIBOR and 3 month LIBOR(CHF) (01.01.1990 11.11.2011;
prior 1999 VIBOR instead of EURIBOR is used) ....................................................... 18
Figure 11: EUR/JPY (daily averages 01.01.1990 11.11.2011; prior 1999
ATS is converted by 13.7603 per EUR) ..................................................................... 19
Figure 12: 3 month LIBOR JPY and interest rate differential between 3
month EURIBOR and 3 month LIBOR(JPY) (01.01.1990 11.11.2011;
prior 1999 VIBOR instead of EURIBOR is used) ....................................................... 20
Figure 13: Deutsche Bank G10 Currency Harvest EUR Excess Return
Index (18.09.2000 11.11.2011)............................................................................... 27
Figure 14: Outstanding debt comparison of domestic versus foreign
currency borrowing .................................................................................................... 36
Figure 15: Mortgage payment denominated in domestic currency ............................ 38
Figure 16: Outstanding debt comparison foreign currency borrowing incl.
and excl. fees ............................................................................................................ 40
Figure 17: Fee-impact on mortgage interest rate ....................................................... 41
- VII
- VIII
Figure 35: Absolute exchange rate changes and interest differential gains
on JPY borrowings of Austrian non-monetary financial institutions (Q1
1999 Q4 2011)........................................................................................................ 60
Figure 36: Cumulative exchange rate changes and interest rate differential
gains on JPY borrowings of Austrian non-monetary financial institutions
(Q1 1999 Q4 2011)................................................................................................. 60
Figure 37: Absolute total profits of CHF and JPY borrowings of Austrian
non-monetary financial institutions (Q1 1999 Q4 2011) .......................................... 61
Figure 38: Cumulative exchange rate changes and interest rate differential
gains on CHF and JPY borrowings of Austrian non-monetary financial
institutions (Q1 1999 Q4 2011) ............................................................................... 61
Figure 39: Outstanding Austrian private household debt in CHF, absolute
(left scale) and relative (right scale) excluding subsector sole proprietors
(01.2003 12.2011) .................................................................................................. 62
Figure 40: Outstanding Austrian private household debt in JPY, absolute
(left scale) and relative (right scale) excluding subsector sole proprietors
(01.2003 12.2011) .................................................................................................. 63
Figure 41: Cumulative exchange rate changes and interest rate differential
gains on CHF borrowings of Austrian private households (Q1 1999 Q4
2011) ......................................................................................................................... 64
Figure 42: Cumulative exchange rate changes and interest differential
gains on JPY borrowings of Austrian private households (Q1 1999 Q4
2011) ......................................................................................................................... 65
Figure 43: Cumulative profits of CHF and JPY borrowings of Austrian
private households (Q1 1999 Q4 2011) .................................................................. 65
Figure 44: Outstanding debt comparison of balloon loan versus standard
domestic and foreign currency borrowing .................................................................. 68
Figure 45: Comparison of interest rates between borrowing and
investment returns ..................................................................................................... 70
Figure 46: Long/Short diagram of foreign currency borrowing including a
repayment vehicle ..................................................................................................... 72
Figure 47: Fee-impact on mortgage interest rate of a balloon loan ........................... 74
Figure 48: Intermediation spread between 10 year Austrian government
bond yield and 3 month EURIBOR (VIBOR before 1999, 01.02.1994
15.11.2011) ............................................................................................................... 78
Figure 49: Intermediation spread between 10 year Swiss and Japanese
government bond yield and 3 month CHF respectively JPY LIBOR
(01.02.1994 15.11.2011) ........................................................................................ 78
- IX
-X
Index of Equations
Equation 1: Covered interest rate parity .................................................................... 21
Equation 2: Forward exchange rate ........................................................................... 21
Equation 3: Uncovered interest rate parity................................................................. 22
Equation 4: Unbiasedness hypothesis ....................................................................... 22
Equation 5: Regression analysis on the unbiasedness hypothesis ........................... 23
Equation 6: Expected currency carry trade return (money market) ........................... 26
Equation 7: Expected currency carry trade return (forward market) .......................... 26
Equation 8: Annuity in a mortgage payment .............................................................. 35
Equation 9: Mortgage payment (including exchange rates) ....................................... 37
Equation 10: Mortgage payment including fees (and exchange rates) ...................... 40
Equation 11: Private household portfolio including foreign currency
borrowing ................................................................................................................... 42
Equation 12: Quarterly returns currency carry trading (EUR/FCU) ............................ 47
Equation 13: Real debt on foreign currency borrowing .............................................. 58
Equation 14: Constant payments for a balloon loan including a repayment
vehicle ....................................................................................................................... 66
Equation 15: Private household portfolio including foreign currency
borrowing (balloon loan) with a repayment vehicle .................................................... 71
Equation 16: Internal rate of return on a balloon loan including transaction
costs .......................................................................................................................... 73
Equation 17: Excess return on foreign currency loan funded investments ................ 81
- XI
List of Abbreviations
ATS
Austrian shilling
AUD
Australian dollar
BMSK
bn
billion
CAD
Canadian dollar
CAPM
CFA
CHF
Swiss franc
CME
DEM
German mark
EEIG
ETF
EU
European Union
EUR
Euro
EURIBOR
FCU
FMA
FRF
French franc
GBP
British pound
JPY
Japanese yen
LIBOR
LTCM
MSCI
- XII
NBER
NOK
Norwegian krone
NZD
OECD
OeNB
S&P 500
SEK
Swedish krona
SR
Sharpe ratio
TED
USD
VIBOR
WKO
- XIII
Executive Summary
This thesis investigates the role and performance of foreign currency denominated
debt to Austrian private households. In a highly industrialized country this kind of
loans should normally play a minor role in the borrowing behaviour. However, it
increased enormous within few years reaching a substantial share in Austrian private
household debt.
However, the recent financial crisis caused abysmal losses due to the strength of
CHF and JPY versus the euro (EUR) and because of the bad performance on the
investment products used as repayment vehicles. Since October 2008 the new issue
of foreign currency loans has been de facto forbidden, followed by a prohibition in
2010.2
This topic is often discussed controversially, whereas on the one hand side
promoters refer to advantages for borrowers (and the whole economy) due to lower
costs, while sceptics warn about the substantial risks related to this loan strategy.
Therefore the aim of the following thesis is to provide background knowledge, a
theoretical overview and empirical evidence.
- XIV -
The main question of this paper is to assess the profitability of foreign currency
borrowing versus equivalent domestic currency loans respectively the payoff on
balloon loans including a repayment vehicle.
The assessment of excess returns of foreign currency loans follows the academic
literature on currency carry trading. Returns are calculated on quarterly basis for the
timeframe from 1990 until 2011. Generated results abstracting from the impact of
transaction costs are on CHF borrowings almost zero and in JPY slightly positive
(arithmetic means around 0.28% and geometric ones around 0.09%). However, Sharpe
ratios are quite low even before and also after deducting transaction costs (CHF
around zero and JPY 0.09 before and 0.07 after costs). Portfolios funded one half in
each currency (CHF and JPY) generated even smaller Sharpe ratios than pure JPY
borrowings (i.e. there has been no benefit of diversification by using both currencies
instead of one).
Austrian non-financial foreign currency borrowers generated between 1999 and 2011
a cumulative loss on CHF borrowings of approximately 5.6 billion EUR and a profit in
the same size on JPY ones (i.e. in sum, foreign currency loans have been a zero
sum game). Extracting private household borrowers only results in a total cumulative
loss of 0.7 billion EUR.
- XV -
funded via CHF and JPY borrowings. While this strategy generated at least in the
frictionless world (no costs and taxes, and financing for the risk-free rate) positive
quarterly returns (arithmetic and geometric) for both currencies, risk-adjusted returns
are still not very attractive (Sharpe ratios around 0.15 for CHF, respectively 0.2 for
JPY funded MSCI World investments).
However, real world constraints like fees, taxes fees and the inability to borrow to the
risk-free rate diminish returns substantially. While CHF borrowed equity investments
show negative results only (arithmetic and geometric), JPY ones exhibit slightly
positive arithmetic means, but negative geometric ones. Sharpe ratios are in all
cases close to zero for both currencies. Cumulative losses within 22 years shrunk the
invested capital by nearly one half for CHF respectively one third when used JPY
borrowings for stock market investments.
Summing up, foreign currency borrowing (with or without repayment vehicle) has in
terms of profitability and risk-reward adjusted returns not been a successful
substitution for conventional domestic denominated loans but exposed private
households to substantial risks.
- XVI -
1 Introduction
A highly industrialized country with huge accumulated internal financial wealth and
own currency should have enough internal capability and infrastructure to transfer
money from people with financial surplus to people with financial demand. Therefore
borrowing denominated in foreign currency usually plays no important role in such
countries. However, the borrowing behaviour in a small country at the heart of
Europe puzzles to economists and has important implications for the wealth situation
of a large minority of private households.
The share of foreign currency loans in Austrian private households has been
negligible prior the mid of the 1990s, until it increased substantially within few years,
reaching a substantial level in total private household debt.
Austria is one of the richest countries in the world (measured by per capita gross
domestic product, private household wealth and financial assets) and offers a
competitive banking system. Therefore, there should be no economic reason to
explain this exceptional borrowing behaviour. Various papers have been written to
explain this different behaviour compared to other countries with similar conditions,
but none of them is able to provide a comprehensive explanation (but still add
important parts to a bigger picture). However, theories on behavioural finance and
specific market conditions contribute to the understanding.
Via their subsidiaries, Austrian banks even exported foreign currency loans to
eastern European countries where foreign currency borrowing reached in some
countries a market share far higher than in Austria.
-1-
therefore relevance to the stability of the financial system in Austria.5 The FMA noted
in 2010 with a publication that foreign currency loans are according to the banking
law not a mass product and not an adequate housing loan product for private
households.6 In 2008 the FMA recommended banks to forego granting new foreign
currency loans to private households,7 followed by a prohibition (with very few
exceptions) in 2010.8
With growing popularity, borrowing in foreign currency has been confronted with
scepticism. Discussions about this topic are usually controversial and often
emotional. While supporters claim advantages due to lower borrowing costs leading
to an increase in private household wealth and has therefore a positive effect on the
overall domestic economy, opponents warn about the risks associated with this
innovation. However, opinions are often biased due to personal involvements (e.g.
people either holding a position in this product or selling them actively). Therefore,
the principal motivation is to write this paper with the mission of the highest possible
degree of objectivity.
The main task of this thesis is to assess the profitability and suitability of foreign
currency borrowing as substitution of conventional domestic currency loans for
Austrian private households. In addition the paper should provide a profound basis to
the interested reader for further research.
The first section addresses the size and structure of foreign currency denominated
debt in Austrian private households including an overview of potential reasons for the
special borrowing behaviour in this country.
In the next section, the paper shows the history of the main important exchange rates
and interest rates. This part gives also an overview of the theory on nominal
exchange rate parity including a summary on the academic literature on the validity
of uncovered interest rate parity.
-2-
Since this kind of loan is mostly constructed as balloon loans with repayment vehicle,
Chapter 5 assesses the return on this strategy. Equivalently to the carry trade excess
returns, the payoff of CHF and JPY funded equity market investments (represented
by the MSCI World index) are reported.
The latter part gives an overview of conflicts in interest due to the commission based
compensation scheme between the principal (private household) and the agent
(financial advisor). This might have a severe impact on the implementation of private
household borrowing.
Besides a summary of the findings and concluding remarks, the last chapter provides
general insights important for personal finance and tries to open the door for future
research.
-3-
35%
30%
25%
20%
15%
10%
5%
0%
Figure 1: Share of foreign currency loans of total private household loans (Q1 1987 Q2 2011)
The popularity of foreign currency loans started from the western part of Austria and
spread out over the years into the eastern provinces.10 In the late 1980s the share of
loans in foreign currency in private household borrowing has been 4 to 5% in
Vorarlberg while in Austria as a whole it was very small portion of 0.2%, what can be
explained rational by the comparable large share of people living in Vorarlberg and
working in Switzerland or Liechtenstein, and getting therefore their income in Swiss
francs.11
-4-
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Q4 2002
Q4 2003
Q4 2004
Q4 2005
Q4 2006
CHF JPY
Q4 2007
Others
Q4 2008
Q4 2009
Q4 2010
Figure 2: Currency distribution of Austrian foreign currency private household debt (Q4 2002
13
Q2 2011)
12
13
-5-
By looking how private households plan to repay their debt it is visible that almost all
of the balloon loans are structured with a repayment vehicle which is an investment
product with higher expected returns than the borrowing costs are. While the
outstanding debt in euro which should be covered with a repayment vehicle is just
4% of all borrowings in this currency it is 74% from all Swiss franc respectively 72%
in yen (see Figure 3).
100%
90%
87%
85%
81%
80%
74%
72%
65%
70%
60%
50%
35%
40%
25%
30%
20%
19%
15%
10%
13%
4%
0%
EUR
CHF
JPY
Continous Repayment
Balloon Loan
ALL
14
The by far largest portion of all balloon loans including a repayment vehicle is
denominated in Swiss franc with 84.4% (see Figure 4). This does not come with a
surprise due to the large share of foreign currency loans in general, which are mainly
balloon loans and dominated by the Swiss franc as funding currency.
JPY
4.6%
Others
0.1%
EUR
10.8%
CHF
84.4%
Figure 4: Balloon loans with repayment vehicle per currency (Q2 2011)
14
15
-6-
15
The residual maturity of private household balloon loans with repayment vehicle of
most of the outstanding volume is between 15 and 20 years (see Figure 5). So the
highest outstanding volume is exposed to exchange rates and asset values of the
repayment vehicles between the years 2025 to 2030 except for the circumstance that
until this time a lot of households switch the funding currency to euro and unwind
their repayment vehicles and use the proceeds for repaying the outstanding debt.
bn EUR
9
8
7
6
5
4
3
2
1
0
daily
<1M.
1-3M.
2-3Y.
EUR
3-4Y.
CHF
4-5Y.
5-7Y.
JPY
Figure 5: Residual time to maturity of balloon loans with repayment vehicle (Q2 2011)
16
16
-7-
60%
50%
40%
40.0%
30%
20%
10%
0%
Q2 2004
2.7%
Q2 2005
Q2 2006
Q2 2007
All Currencies
Q2 2008
Q2 2009
Foreign Currency
Q2 2010
Q2 2011
Figure 6: Austrian share of private household debt within the European Monetary Union (Q2
17
1994 Q2 2011)
In the whole European Monetary Union just 2% of the private household debt is
denominated in foreign currency while Austrian private households have 29.6% of
their borrowings in a currency other than euro (see Figure 7). This shows that the
borrowing behaviour in Austria is very different to the average private houehold in the
European Monetary Union.
35%
30%
29.6%
25%
20%
15%
10%
5%
2.0%
0%
Q2 2004
Q2 2005
Q2 2006
Q2 2007
Euro-Area
Q2 2008
Q2 2009
Austria
Q2 2010
Q2 2011
Figure 7: Share of foreign currency debt of total private household debt (Q2 1994 Q2 2011)
18
-8-
per month), are younger and more likely to be self-employed.20 Interestingly is also
the finding that 27% of foreign currency borrowers named independent financial
advisors as one of their information source for financial issues while just 13% of euro
borrowers did.21
20
-9-
therefore the related lower monthly payments are the most important arguments.29
This finding is consistent with a questionnaire among customers of foreign currency
loans where the lower interest rate level and lower monthly payments are named as
main reasons for choosing this form of borrowing.30
While the lower interest rate level can provide an explanation of the behaviour of
Austrian private households to use foreign currency loans it fails to explain why
Austria is so different from other countries in the European Monetary Union because
the euro adoption created also a common interest rate level (EURIBOR), so private
household borrowers in other countries of the Euro-Area should show a borrowing
behaviour similar to Austrian private households.
Real-life examples show that the credit spread charged on the EURIBOR as base
rate after switching a foreign exchange loan into euro is in most offers the same as
the previous spread on the respective LIBOR in the previous currency. 32 So if the
lending institution would offer a higher credit spread in domestic currency, a borrower
could create this credit spread arbitrage by taking a foreign currency loan, switch
into euro simultaneously and get therefore the foreign currency credit spread for a
euro-loan. But as this switching approach seems to be not widely used, the credit
spread argument is weak.
29
- 10 -
10%
8%
6%
4%
2%
0%
Q3 1995
Q3 1996
Q3 1997
Q3 1998
Q3 1999
Austria
Germany
Q3 2000
Q3 2001
Q3 2002
Q3 2003
France
Figure 8: Not harmonized retail bank interest rates for housing loans to private households (Q2
33
1995 Q2 2003)
One explanation for the spread argument could be a misinterpretation of the terms
intermediation spread versus credit spread. While the intermediation spread is the
difference in the rate at which a bank borrows money from their savings customers
(e.g. in form of savings deposits) and the rate at which the bank lends it to their
borrowers, the credit spread is the difference of the interest rate on a loan to the
market interest rate like the EURIBOR or LIBOR. This could also explain why
practitioners claim that banks earn more in euro-loans34 and may conclude to a more
expensive financing in the domestic currency.
A second potential explanation for different credit spreads (if the reality shows them)
could be price pressure due to different competition in different currencies. This might
33
34
- 11 -
occur when price comparisons and negotiations are more common in foreign than
domestic currency borrowing which could have been supported by independent
financial advisors.
Furthermore could adverse selection partly explain a different credit spread because
when the average foreign currency borrower receives a higher income and is higher
educated, the lending bank may agree to narrow the credit spread due to the lower
riskiness which the bank faces.
35
c.f. p. 4
cf. Waschizek 2002: pp. 95 98, translation by the author
37
cf. Waschizek 2002: p. 97, translation by the author
36
- 12 -
because of the historic popularity in the western part and structural changes which
supported this behaviour.38
Nevertheless due to some concerns herding behaviour can just partly explain the
Austrian situation.39
Additional costs for borrowing in foreign currency compared to euro arise. The bidask spread is one of them and has to be paid at first after receiving the borrowed
amount (which is denominated in the foreign currency and has therefore to be
converted to euro) and afterwards for each interest and redemption payment.46 The
size of the spread depends on the currency and the lending bank, is usually between
0.8% and 1.4% and can be partially lowered through negotiation.47 Additional
transaction costs for repayment, interest payments and currency switches of about
38
- 13 -
0.275% arise.48 Rough calculations show that the effective interest rate increases by
0.14% for a 20 year loan (respectively by 0.44% for a 5 year loan) just because of
foreign currency transaction costs (excluding currency switches which lead to a
further increase of the effective interest rate).49 Additionally banks charge up to 100
euro for a necessary clearing account, extra fees for switching the funding currency
or the repayment vehicle.50 Comparisons across Austrian largest banks also showed
that some extra fees increased partially dramatically within few years (e.g. one bank
increased the switching fee for the repayment vehicle by 1.050% to 229 euro in one
year).51
Due to the higher risk banks require more collateral compared to a euro denominated
loan of the same size like a higher property lien which leads to higher taxes 52 and
also a higher face amount of a required life insurance increases the premium
therefore.
48
- 14 -
In 1995 Austria joined with the ATS the Exchange Rate Mechanism of the European
Monetary System.59 This mechanism was an arrangement of fixed exchange rates in
order to decrease the exchange rate volatility among the member states.60 Few years
later, in 1999, the EUR was established as common currency of first 11 member
53
- 15 -
states and counts as of today 17 members.61 Austria became part of the new
currency in 1999 with a conversion rate of 13.7603 ATS for one EUR.62
Prior to this market turmoil and decline of the EUR the exchange rate versus the CHF
seemed to be very stable. During the 1990s the EUR depreciated steadily by about
1.1% per year until 2000. Since then the EUR went in a phase of continuous
appreciation until the start of the period of the recent decline and reached nearly
parity to the EUR in August 2011. Nevertheless the currency pair EUR/CHF gives ex
post most of the time an impression of a smoother development than other financial
assets, e.g. stocks.
61
- 16 -
2.0
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1.0
0.9
0.8
Figure 9: EUR/CHF (daily averages 01.01.1990 11.11.2011; prior 1999 ATS is converted by
64
13.7603 per EUR)
Today the CHF is the strongest currency in the world which is supported by worlds
lowest inflation rate during the last century.65 The strong currency, Swiss neutrality
and solid policy made Switzerland a safe haven.66 The strength of the CHF boosted
the average wealth in Switzerland to the top of the world in the last century.67
From 1990 onwards the short term interest rate (measured by the 3 month LIBOR) of
the CHF fell very sharp from close to 10% at the beginning of the period to around
2% in the last quarter of 1995. It remained at a low level for most of the time except
two periods from 2000 until 2002 and 2007 until 2009 where it reached a peak
around 3% (see Figure 10, light line).
The interest rate differential between the 3 month CHF LIBOR and the 3 month
EURIBOR (respectively the 3 month VIBOR prior 1999) has been positive over the
whole period except for the year 1990 (see Figure 10, dark line). On average the
interest rate differential was around 145 basis points which is roughly the point where
it is today. Interest rate differential remained very stable most of the time in a range
between 100 basis points and 200 basis points from 1995 onwards.
64
- 17 -
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
LIBOR CHF
EURIBOR - LIBOR(CHF)
Figure 10: 3 month LIBOR CHF and interest rate differential between 3 month EURIBOR and 3
68
month LIBOR(CHF) (01.01.1990 11.11.2011; prior 1999 VIBOR instead of EURIBOR is used)
It is visible that EUR/JPY is far more volatile than the EUR/CHF (see Figure 9 and
Figure 11, the scaling is equivalent but multiplied by the factor 100 due to the higher
nominal exchange rate level of the EUR/JPY).
Compared to the EUR/CHF exchange rate the movements of the EUR/JPY seem to
be much more unstable, and seem to be very unpredictable. Therefore future
expectations of the exchange rate development based on the recent past experience
have to struggle with much more uncertainty compared to EUR/CHF.
68
- 18 -
200
190
180
170
160
150
140
130
120
110
100
90
80
Figure 11: EUR/JPY (daily averages 01.01.1990 11.11.2011; prior 1999 ATS is converted by
69
13.7603 per EUR)
Similar to Switzerland (and most developed countries in the world), Japan had a very
high short term interest rate (3 month LIBOR) in the beginning of the 1990s which
declined below 1% in 1995 (see Figure 12, light line). From 1999 onwards the level
was close to zero with two short periods in time where it has risen slightly but
remained mostly below 1%.
This finding should not come as a surprise as compared to most countries in the rest
of the world Japan faced difficulties within the last two decades. Since the asset price
bubble burst in 1990 Japan faced a period of continuous stagnation and deflation.70
This very low level of the nominal short term interest rate in Japan induced a higher
interest rate differential to the comparable EUR rate as the CHF one. On average the
differential between the 3 month JPY LIBOR and the EURIBOR (respectively the
VIBOR prior 1999) was around 275 basis points which is by far higher than today due
to the low interest rate level in the Euro-Area.
69
70
- 19 -
11%
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
LIBOR JPY
LIBOR - EURIBOR(JPY)
Figure 12: 3 month LIBOR JPY and interest rate differential between 3 month EURIBOR and 3
71
month LIBOR(JPY) (01.01.1990 11.11.2011; prior 1999 VIBOR instead of EURIBOR is used)
Covered interest rate parity is the condition when there is no arbitrage opportunity
between the spot and forward exchange rates of two currencies and the
corresponding nominal interest rates.72 Assume a speculator borrows in a lowyielding currency convert and invests the proceeds in a high-yielding one including
the decision to hedge the foreign exchange exposure fully via a forward contract. If
the no-arbitrage condition of the covered interest rate parity is fulfilled the forward
rate should erase the positive interest rate differential completely.
Equation 1 has therefore to hold, where iL stands for the interest rate of the
investment currency (L = long), iS the interest rate of the funding currency (S = short),
St the spot exchange rate and Ft the respective forward exchange rate (both
exchange rates stand for units of the short currency per one unit of the long
currency).
71
72
- 20 -
Equivalently this formula can be used to calculate the forward exchange rate (see
Equation 2) as in practice banks often do for quoting outright forward contracts.73
In normal times deviations from covered interest rate parity are very rare and persist
only in a small size for a very short time until transactions of arbitrageurs bring the
rates in equilibrium.74 In times where market volatility becomes higher the duration
and size of arbitrage opportunities usually increases which the recent financial crisis
has shown.75 Nevertheless observed violations of the covered interest rate parity
may not provide real arbitrage opportunities since counterparty default risk, political
risks and exchange rate controls can explain why arbitrage trading might not lead to
riskless profits.76
- 21 -
Under this condition the expected future spot exchange rate has to be equivalent to
todays correspondent forward exchange rate. This is called the unbiased hypothesis
whereas the systematic difference of the forward rate and the expected future spot
rate is zero (see Equation 4) hence a speculator cannot expect a forward market
return.78
Since forecasting exchange rates is a very difficult task even forecasts of commercial
firms are widely dispersed and no one seems to be successful in the long run.79
Empirically tests on the validity of the unbiasedness hypothesis have to deal with the
difficulty of observing future exchange rate expectations of market participants and
therefore imply the assumption of rational expectations.80
A comparison of the mean rate of appreciation and the mean forward premium of a
given data set can assess the overall average performance of the theory during this
time period.81
To test explicit the theoretical implications of the unbiasedness hypothesis the most
common way in the academic literature is to derive the results by a regression
analysis. Equation 5 shows the regression based on observable information in the
market whereas St stands for the current spot rate, St+1 the future spot rate (observed
at time t+1), respectively iS for the interest rate on the funding currency and iL as
correspondent interest rate of the investing currency (exchange rates are units of
funding currency by one unit of investing currency). In the literature the left hand side
78
- 22 -
of the equation is most common expressed by the difference of the natural logarithms
of St+1 and St.82
Under the null hypothesis the regression should result for =0 and =1 whereas most
studies in the literature focuses on the slope .83 The term t+1 denotes for the
forecast error which implies under rational expectations that the conditional mean
and unconditional mean of the error are zero.84
Empirical evidence also shows often a negative correlation between current interest
rate differentials and the expected exchange rate changes (i.e. high-yielding
currencies appreciate, whereas low-yielding currencies depreciate on average) which
is called the forward premium puzzle.85
An investigation of over the last two centuries (1800 1999) with short-term and
long-term interest rates for the United States, United Kingdom and France and
exchange rates of the US dollar (USD) versus the British pound (GBP) and the
French franc (FRF) versus the GBP basically results that uncovered interest rate
parity works better over long time periods and longer investment horizons.86 The
forward premium regressions on short and long term interest rates for both currency
pairs give positive slope estimates () in all four cases whereas for FRF/GBP (for
the long term rate 0.73 respectively 0.97 for the short term rate) is not significantly
different from one while the estimates for USD/GBP are significantly different from
82
- 23 -
unity ( for the long term rate 0.39 respectively 0.14 for the short term rate).87 The
conclusion is that even when the uncovered interest rate parity is violated during
short periods the forward premium puzzle disappears over the long run. 88 Further
findings provide the evidence that long term interest rates are better predictors of
currency movements than short term interest rates89 and larger interest rate
differentials have a significantly higher forecasting power on future currency
movements.90 By running a rolling forward premium regression it turns out that prior
the early 1970s the slope estimates () are not significantly different from the null
hypothesis (unity) but started to become negative afterwards until the 1990s when it
turned back to a positive value again.91
A further study using monthly data between 1976 until 2010 including USD, JPY,
GBP and EUR (former DEM) results that the ex post rate of appreciation and the ex
ante forward premium are very different but due to large standard errors and low
confidence levels the confidence is not high enough to reject the null hypothesis that
the difference is zero (highest confidence level with 0.59 for the USD/GBP).92 As
summarized result there is no evidence that the unconditional means of the forward
premiums and the appreciation rates are different which implies that the average
forward market returns are zero.93
New light into the forward rate anomaly sheds an analysis of 28 emerging and
developed countries between 1976 and 1998 with 1-month and 3-month horizons
based on the USD.95 Even though uncovered interest rate parity is rejected for all
countries the result suggests only little evidence for the forward premium puzzle.96
87
- 24 -
Especially in developed economies with lower per capita income and emerging
economies does not show evidence for the forward premium puzzle as high income
economies do.97 Furthermore the slope-coefficient () is larger in countries with lower
per capita income, lower country ratings and higher inflation uncertainty while high
income countries with high ratings and low inflation uncertainty are more likely to
show a negative slope-coefficient.98 The main conclusion is that the forward rate
puzzle is confined to high income economies and especially when the USD interest
rate exceeds foreign interest rates.99
If the unbiasedness hypothesis is not valid and someone can successfully derive the
bias quantitatively it might open profit opportunities.
- 25 -
the proceeds in a higher yielding one. If the exchange rate remains unchanged the
speculator receives the carry which is the differential between the higher and the
low interest rate.105 The carry trade strategy can be implemented in various ways
either by using the money market (low yield borrowing and high yield lending as
described) or via derivatives (forwards, futures, options or swaps).
Equation 6 provides the expected return on the carry trade implied in the money
market. The notations are again Et(rt+1) for the expected return, Et(St+1) for the
expected future spot rate, St for the current spot rate, iL for the interest rate in the
long position and iS for the interest rate in the short position (the exchange rate St
denotes for units of the funding currency per one unit of the investing currency).
The same strategy can be implemented without any upfront money flow via forward
contracts. Equation 7 shows the expected return equivalent to the money market
carry trade return (same notations as in the previous equation including F t for the
forward exchange rate).
By replacing the expected future spot rate E(St+1) to the future spot rate observed in
the market St+1 both equations (Equation 6 and Equation 7) can be used to calculate
ex post the realized return on the carry trade strategy.
- 26 -
chooses among them each quarter three investing currencies (currencies with the
highest LIBOR) and three funding currencies (currencies with the lowest LIBOR). 106
The index consists of long positions in three month forward contracts in the
investment currencies respectively of equivalent sized short positions in the funding
currencies (all equally weighted and rebalanced every quarter). 107 It is calculated as
excess return index (i.e. unfunded investment) and does not take into account
transaction costs or bid-ask spreads (calculated with mid rates).108
The index development is characterized by a steady upward trend from 2000 until the
mid of 2007 when the recent financial crises started (see Figure 13). From 2007
onwards the index started to decline where especially the months after the collapse
of Lehman Brothers in 2008 caused a huge drop in the index level. (-7.12% in
September 2008 and -14.23% in October 2008).109
200
180
160
140
120
100
80
60
40
20
0
Q3 2000 Q3 2001 Q3 2002 Q3 2003 Q3 2004 Q3 2005 Q3 2006 Q3 2007 Q3 2008 Q3 2009 Q3 2010 Q3 2011
Figure 13: Deutsche Bank G10 Currency Harvest EUR Excess Return Index (18.09.2000
110
11.11.2011)
From the portfolio perspective it is worth noting that since 2001 (until April 2011) the
index had never a net exposure in EUR (as well as the CAD) and used the EUR
106
- 27 -
partly in 2000 as funding currency.111 From 2000 onwards (until April 2011) the CHF
and JPY where exceptionalness used as funding currencies whereas the AUD and
NZD have always been investing currencies while the USD and the NOK where
partially used and even switched side.112
During the financial crisis in 2008 the daily returns of the index where highly
correlated to stock market returns.113 The carry trade strategy also suffered from
substantial losses in 1997 during the Asian financial crisis and in the Russia crisis
1998 where LTCM collapsed.114
111
- 28 -
might find an explanation in the credit premium of the US commercial papers which
are used as USD short term interest rate.116
A study based on daily exchange rates and interbank interest rates of 20 major
countries (converted into monthly non-overlapping observations) from 1976 until
2009 delivers an average mean return on the USD as base currency of 4.9% without
incorporating transaction costs and a Sharpe ratio (SR) of 0.44.117 An equallyweighted currency carry trade portfolio therefore offers a SR of 0.91 due the sharp
decrease of the standard deviation meaning there are huge benefits of
diversification.118 Nevertheless the distribution of portfolio payoffs are leptokurtic and
fat tailed.119 Investigations including data until the end of 2010 show similar results
with an average SR of 0.42 for the individual currencies (mean return 4.6% and
standard deviation 11.3%) respectively a SR of 0.89 for the carry trade (mean 4.6%
and standard deviation of 5.1%) while US stocks performed with a SR of 0.41 (mean
6.5% and standard deviation of 15.7%).120
The equally-weighted strategy involving 23 countries with data from 1976 until 2007
exhibits a SR of 0.83 whereas a high-low strategy (position only in two currencies
with the highest forward premium respectively discount) shows a SR of 0.54 (median
SR of all currencies 0.5) which also provides evidence of diversification gains.121
While payoffs of the currency specific carry trades and the high-low strategy have low
means and fat tails the returns of the equally-weighted portfolio are less skewed than
stock market returns.122
Worth notably is also the investigation is that the equally-weighted carry trade (data
between 1987 and 2009, six currencies, USD as base currency based on monthly
observations) delivers a SR of 0.45 even when the strategy is hedged with close to at
the money options (CME option data) compared to 0.48 in the unhedged version.123
The annualized mean return declines from 3% to 1.6% through the costs of the
116
- 29 -
protection and including transaction costs as well the mean payoff of the equallyweighted hedged carry trade goes back to 1.2%.124 The comparison of payoffs and
SR based on 12-month moving averages exhibits a high correlation between the
hedged and unhedged strategy.125
By comparing currency carry trade returns between the USD and all nine other
currencies of the G10 countries (data on monthly frequency between 1990 until
2007), it turns out that all pairs deliver positive excess returns (three statistically
different from zero) containing a variation of SR of 0.14 (for CHF/USD) to 0.75 (for
SEK/USD).126 However the returns are not normal distributed, exhibit significant
negative skewness and excess kurtosis.127 Focusing on portfolio strategies (equallyweighted respectively spread-weighted) show that Sharpe ratios are close to one
(and statistically significant) and that the carry (the interest rate differential)
represents between 33% and 50% of the total return whereas the remainder is
coming from the currency return.128 Through diversification benefits the volatility of
the portfolios is substantial lower than the average of individual currency pairs
however, the portfolio returns are more skewed and heavier tailed.129 Separating the
portfolios to sub-portfolios for long USD and short USD shows that although all subportfolios generate positive returns only short USD portfolio returns are statistically
significant.130 Data from 1999 until 2007 results that four (AUD, EUR, NZD and SEK)
out of nine currencies deliver statistically significant returns and do so by including
crash risk protection (10 and 25 options) but with a significant decline of returns
due costs of the options.131 For AUD and SEK the returns remain significant even
with hedging via at the money options.132 From the portfolio perspective it turns out,
that only portfolios which are not USD neutral (i.e. portfolios including net dollar
exposure) have statistically significant returns whereas in hedged portfolios which are
constraint to have zero net USD exposure statistically significant returns are
eliminated.133
124
- 30 -
Traditional models as CAPM deliver either insignificant results (for an equallyweighted carry trade strategy) or ones which are significant but economically small
(for a high minus low carry trade strategy) and also a Fama-French three factor
model does a poor job.136
However, less traditional risk factors exhibit a tendency that currencies with a high
interest rate level have low returns when equity volatility goes up and vice versa low
yielding currencies offer high returns during these times.137 Focused on historic crisis
periods, high interest rate currencies expose speculators to more market risk while
low interest rate currencies provide a hedge against it.138 There are supportive
findings of a positive correlation (0.19) between the currency carry trade strategy
(G10 currencies) and the returns on the stock market (S&P 500 futures).139 This
positive correlation goes up significantly in times when implied foreign exchange
volatility increases.140 Based on a regime depended model the NZD shows a positive
exposure to S&P 500 whereas CHF and JPY react in the opposite and offer therefore
safe haven qualities.141
134
- 31 -
Currency carry trades may also be exposed to crash risk as high interest rate
differentials forecast negative skewness (versus the USD).142 The finding of negative
skewness for high yielding currencies (AUD and NZD) and positive skewness in low
yielding ones (JPY) shows up in both, the empirical and (option) implied skewness. 143
The size of the skewness in a carry trade portfolio is comparable with the equity
market (value weighted US stock market) and cannot get diversified away which is
consistent to stocks.144 Especially in turmoil times when global risk appetite declines
carry traders unwind their positions, what lead to bad returns.145
However crash risk can be eliminated via hedging and here the empirical finding is
that 15% to 35% of carry trading excess returns come from crash risk.146
Technically a peso problem means that even when skewness which is observed in
the data lacks to explain carry trade returns unobserved skewness could.152
142
- 32 -
An alternative explanation for the peso event is, that instead of huge losses in the
peso state a speculator faces moderate losses but become very risk averse during
this time (high stochastic discount factor).153
For the empirical rejection of the unbiasedness hypothesis (which is closely related to
carry trade returns) a stylized model is able to generate similar slope coefficients ()
as observed empirically and provides therefore evidence that the nature of persistent
autocorrelation of the forward premium in combination with small samples may lead
to unjustified rejections of the theory.154 Partly supportive for this model is the validity
of the theory in the ultra-long sample which suggests that uncovered interest rate
parity holds for the long run (and large interest rate differentials) but fails in the short
run (and small interest rate differentials).155
153
- 33 -
Suppose a private household wants to buy a house and uses (partial) debt financing,
since usually private households do not have enough savings to pay the whole
amount upfront. Typically the missing amount (between total costs and savings) is
borrowed from a lending institution like a bank or a building and loan association. The
private household and the lending institution agree on the terms of the loan like
interest rate, repayment conditions and collateral (typically a mortgage). Naturally
there is no big attention given to the currency of the loan because as borrower and
lender face advantages in using domestic currency (it is assumed that both are
situated in the same currency area) both will naturally agree on domestic as funding
currency. On the one hand, the borrower needs money in domestic currency to make
the payment for buying the house and also generates the future income in domestic
currency which is necessary for repaying the loan. On the other hand, the lender
(bank) collects deposits in domestic currency from other savers (which are used for
paying out the loan amount) and therefore also needs the repayments in the same
currency since the bank faces liabilities denominated in this currency to the savers
(besides this old fashioned style, banks could refinance the outstanding foreign
currency loans on the inter-banking market). There might be some cases, for
example borrowers who have their income, respectively make the investments in
foreign currency, or the lender has deposits only in foreign currency (e.g. in less
developed countries where high loan demand meets low savings supply and the
loans are granted from foreign lenders in their home currency), where the currency
denomination of the loan becomes important. Besides this few exceptions the
currency related to the loan should not be a big issue at all.
However, suppose the borrower expects funding in another currency than domestic
one is cheaper, while capital flow restrictions are low and lenders are willing (either
actively offering or passively forced by competition) and able to supply this
- 34 -
If the expectation of lower borrowing costs is primarily based on the lower interest
rate level abroad instead of fundamental or technical analysis of the exchange rate,
is basically the same nave strategy as used for professional currency carry trading.
- 35 -
The second opportunity would be to pay the same amount as for the domestic
currency loan (2,380 EUR) in the foreign currency borrowing with the advantage of
earlier redemption of the debt (in the example the loan would be redeemed after 20
years instead of 25 years in the domestic currency denominated borrowing). Figure
14 provides the size of outstanding debt for both loans of the numerical example
(outstanding debt in percent of the initially borrowed amount) at each point in time,
when the quarterly annuity in both cases is held constant at 2,380 EUR. The foreign
currency loan example is equivalent to a domestic currency loan with the interest rate
reduced from 4% to 2.5%.
0%
0
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
-25%
-50%
-75%
-100%
Domestic Currency
Foreign Currency
159
Figure 14: Outstanding debt comparison of domestic versus foreign currency borrowing
Through this lowered interest expenses (while the exchange rate remains
unchanged) the borrower created additional wealth (since money is free for other
consumption) and faces either the possibility of consuming the additional wealth over
the lifetime (by holding the maturity constant and making lower quarterly payments)
or consuming the wealth at the end of the period (in fact between year 20 and 25 by
holding the annuity constant). However, there would be a third opportunity by holding
the maturity and the payments constant (i.e. later start of annuity payments, as in the
example after three years), which has the appeal of consuming the wealth
immediately within the first years. Since in reality there is not enough evidence, that
the third approach is taken broadly (and is basically just another variation of the
second one) the following concentrates on the first two possibilities.
Findings show, that on the demand side lower monthly payments are an important
feature for borrowers160 and on the supply side one of the most important arguments
159
160
authors calculations
cf. Market 2003: p. 3, translation by the author
- 36 -
However, the previous results give a more general overview of how effective lowering
interest expenses can be for increasing the wealth situation and which is therefore
not specific to foreign currency loans.
Bringing foreign currency exchange rates into play, the annuity expressed in
domestic currency is depended on the exchange rate (EUR/FCU) at each payment
date (see Equation 9) which leads to a variability of the annuities when expressed in
EUR, even when all other factors are constant (which would lead to constant
annuities under domestic currency borrowing). The numerator in the first term (in
brackets) stands for the debt denominated in foreign currency which is basically the
required amount in EUR (CEUR) times the exchange rate (St) at time t (point in time,
when the loan is taken out).
161
162
- 37 -
3,250
2,750
2,250
1,750
1
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Domestic Currency
Foreign Currency
163
Since uncovered interest rate parity holds in this example (i.e. the depreciation is
equal to the difference in interest rates) a borrower has no advantage from the
foreign currency loan even when the payments are lower in the beginning. First, due
to the higher payments in the second half of the loan-lifetime, the internal rate of
return is equal in both cases, and second, if a borrower attaches value to such
repayment structure (lower annuities at the beginning in exchange to higher ones in
the later) it is possible to replicate it on a domestic currency loan as well.
Equivalently, with perfect forecasting ability of the exchange rates at each point in
time (like in the artificial example) the repayment structure (equally payments at each
point in time) of the domestic currency loan is also replicable on the foreign currency
denominated one.
The example clearly shows that even when domestic and foreign interest rates are
fixed (and therefore known for sure) the borrower has to form expectations of the
exchange rate at each point in time for 100 quarterly payments to decide which
opportunity is favourable overall. With variable interest rates it becomes much more
uncertain, since the borrower has besides the exchange rates also to forecast
domestic and foreign interest rates for comparing and deciding among the two
opportunities. However, while forecasting all unknowns to different points in time is
presumable impossible, in favour of the borrower most foreign currency loans offer
the feature of switching into domestic (or another funding) currency at each point in
time (respectively to each roll-over date, e.g. each quarter).164 Under this condition,
the decision making can be separated in sub-periods, i.e. since the borrower knows
the domestic and foreign interest rates at the beginning of each period (each
quarter), only the future exchange rate (after one period) is uncertain. While in some
163
164
authors calculations
cf. Boss 2003: p. 16, translation by the author
- 38 -
literature this switching option is described as very valuable to the borrower it has to
be treated with caution, because the right to switch into another funding currency
does not include a price (exchange rate) at which the borrower has the right to switch
(a feature of a classical option) and is therefore depended on the uncertainty of the
future exchange rate. However, the roll-over feature has two advantages compared
to professional currency carry trading: First, if it is assumed that the foreign currency
loan is persistently cheaper, transaction costs are lower through this money market
implementation instead of using forward contracts (e.g. the bid-ask spread has to be
paid only once instead of each period) and second while professional carry traders
may be forced to liquidate their position during crisis periods,165 consumer protection
might make it more difficult for the lending institution to force the borrower to unwind
the short position in FCU in order to switch in EUR.
165
166
- 39 -
Plugging in the numbers from the example leads to a quarterly annuity of 2,073 EUR
compared to 2,022 EUR abstracting from all additional transaction costs. Figure 16
provides the comparison of the residual debt at each point in time under the condition
of equal annuities (2,380 EUR as on the domestic currency denoted loan) on both
foreign currency loans (including and excluding transaction fees).
0%
0
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
-25%
-50%
-75%
-100%
Foreign Currency (excl. Fees)
Figure 16: Outstanding debt comparison foreign currency borrowing incl. and excl. fees
167
Even when it seems that transaction costs have just a small impact, they should not
be underestimated. While the loan excluding costs is repaid in 20 years it takes
around eight months more to repay a loan including costs.
Figure 17 exhibits the detailed results using the exemplary numbers which are
basically obtained from real world examples. The annuities are reported on a
quarterly basis while interest rates are annualized through multiplying by four. The
columns of foreign currency borrowing excluding fees and all fees also shows
besides the increase of the annuity the impact on the internal rate of return (by
extracting the term i from Equation 8 through fixing A to 2,073 and C to 150,000)
which increased by 22 basis points (see bottom row). In addition, the table reports
the impact of each single type of cost (bid-ask spread, clearance account, transaction
fees and land register tax) on the annuity and the internal rate of return.
167
authors calculations
- 40 -
EUR
Annuity (EUR)
Interest rate
2,380
4.00%
2,073
2.72%
2,042
2.59%
2,037
2.57%
2,033
2.55%
2,027
2.52%
0.22%
0.09%
0.07%
0.05%
0.02%
168
However, the results do not take into account additional costs for switching the
funding currency and hold therefore just in the case when the borrower stays in the
same funding currency during the whole lifetime of the loan (of 25 years). Switching
fees might become a substantial cost factor especially if it is done several times.
Additionally to the bid-ask spread between the initial and the following funding
currency and the transaction fee (0.275% on the outstanding debt, respectively flator minimum fees around 400 EUR) some administrative fees might arise (0.1% 0.5%).169
The switching costs might also impact, at least to some extent, the decision making
process of the borrower. Suppose the borrower expects a negative return (i.e. the
interest rate differential cannot cover expected exchange rate losses) in the next
quarter (t+1). In a no-cost world switching the loan into domestic currency would be
the rational alternative, but in the real world (including switching costs) the borrower
has to decide whether to switch or not on basis of additional costs versus expected
losses and potential future decisions (i.e. if it is assumed to switch back into FCU at
t+2 it might be cheaper to face losses at t+1 instead of switching twice).
It can be summed up that fees are considerably higher on foreign currency than on
EUR loans, which becomes especially important when interest rate differentials
tighten.170
168
authors calculations
cf. Kollmann/Prantner 2006: p. 5, translation by the author
170
cf. Kollmann/Prantner 2006: p. 6, translation by the author
169
- 41 -
The value of the portfolio (at time t) consists basically of the current market value of
the investments (mostly a house) which is commonly denominated in EUR (if it is
located domestically) plus the present value of all expected future income
(dependent on the employer and typically also denominated in EUR) minus the
market value of debt converted in EUR (with the current spot price at time t).
Clearly, the volatility of the portfolio value is higher when using a foreign instead of
domestic denominated loan due to the impact of exchange rate movements.
- 42 -
Additionally the table exhibits the standard deviations (annualized by the square root
of 252) of EUR/CHF and EUR/JPY daily changes.
Since currency carry trading is exposed to aggregate risk,172 also the whole private
household portfolio value is exposed to the same. This holds especially when
correlation increases during bad times, impacting therefore negatively the wealth
situation of the private household. Suppose, during domestic financial turmoil,
leading to economic problems (decreasing gross domestic product, falling stock and
real estate prices, etc.), a borrower might face troubles to afford regular repayments
due to a decrease in income (this problem might occur even in EUR borrowings). But
if furthermore the home currency depreciates sharply versus the funding currency,
the outstanding debt as whole and sometimes even regular repayments might
become an unbearable burden for the borrower. In this case the market value of the
investment (house) and present value of the expected future income goes down,
while the market value of the debt increases due to unfavourable exchange rate
movements. This becomes especially severe, when the borrowing currency offers
safe haven qualities and appreciates during these times.
At least to some extent risky is also the way of consuming the created wealth of
foreign currency borrowing (i.e. lower annuities instead of shortening the maturity),
because if uncovered interest rate parity holds in the long run (during the lifetime of
the loan) and the EUR depreciates sharply versus FCU to bring rates in equilibrium,
the borrower has to cover the losses either by higher payments in the future or
extending the maturity (which requires the agreement of the lender).
- 43 -
100%
50%
EUR
0%
0
25
FCU
-50%
-100%
173
While a typical carry trade has on the long-side a return generating asset (e.g. money
market investment), the position for foreign currency borrowing is the substituted
EUR loan (therefore an implicit investment), which generates the returns through
lower annuity payments. This offers one advantage, because foreign currency LIBOR
is an ask rate which just replaces a domestic currency ask rate (EURIBOR) leading
to a higher interest rate differential comparable to funding via an ask rate (LIBOR) in
one currency and lending at a bid rate in another.
Through continuous repayments the nominal exchange rate exposure decreases, i.e.
exchange rate movements closer to the maturity have less impact on the absolute
profit or loss expressed in EUR than movements at the beginning. Hence, also the
gain, expressed in absolute money, from the interest rate differential becomes less
as more of the loan is redeemed.
Consequently, it follows that under this structure the profit in absolute terms is
dependent on the chronological order of quarterly returns, because even if on
average funding in FCU might be cheaper than in EUR (positive quarterly arithmetic
and geometric mean returns) a big drop of EUR/FCU at the beginning of the loan
lifetime might not get recovered by future positive interest rate differentials while vice
versa big exchange rate losses at the end might not diminish the return towards zero
(even when uncovered interest rate parity holds in the long run). In other words, for
173
authors calculations
- 44 -
the successful currency substitution with focus on quarterly returns, but under the
expectation of holding the debt until maturity, the dollar-weighted rate of return
(internal rate of return) is much more important than the time-weighted rate of return
(geometric mean).
Furthermore, private household currency carry trading has one big disadvantage to
professional currency carry trading, for the reason that while the latter has the
ability of choosing the funding (short position) and investing (long position) currency,
a private household is constraint to choose only the short side because the long side
is simply the substituted EUR loan, which would have been taken instead. Hence,
while the professional one (e.g. Deutsche Bank G10 Currency Harvest, see Chapter
3.5.2) can generate returns by funding in low yielding currencies and investing in high
yielding ones, private households can just gain from funding in a low yielding
currency and implicit investing in EUR (implicit, because the return is coming from
lowering the costs instead of classical investing). This differentiation is very important
because deriving potential gains in borrowing substitution from currency carry trading
lacks the fact that returns might be driven on the long side as well and not just on the
short side. This specially holds when the home currency of the borrower is not a
classical investing currency, like AUD or NZD (i.e. when an Australian borrower
substitutes an AUD loan by a JPY loan).
- 45 -
Furthermore, as most loans started around 10 and 15 years ago (see Chapter 2.1)
the result is strongly dominated by this period in time and as these loans are
currently just in the middle of their lifetime, returns until maturity cannot be obtained.
A second way used in some literature is creating artificial loans and back-testing
them on historic interest rates and foreign exchange rates.175 While this has the
advantage of reporting returns at each point in time (also cost impacts can be
modelled) it struggles with other constraints. First the typical lifetime of these loans
(25 years)176 makes it difficult for back-testing, because market constraints in the
past might have prohibited this opportunity, and second it is nearly impossible to
create several non-overlapping 25 year periods. Using overlapping 25 year periods
(starting therefore sometime in the 1980s) for exploiting the data creates the problem
that the track record is basically similar for all loans and since the history will not
repeat itself (i.e. sometimes a financial crisis would occur at the beginning not always
at the end of a loans lifetime), general conclusions are hard to draw.
175
176
- 46 -
The decision of the timeframe from 1990 until 2011 is based on the fact that during
this period foreign currency borrowing became popular (i.e. it is therefore the most
important timeframe), and the liberalization of the financial market (fully liberalized
since November 1991)177 which offered the opportunity to use this instrument.
Excess returns are calculated by using flat interbank interest rates (i.e. without credit
spreads) for the reason that if the credit spread is equal in both borrowing
opportunities the result including credit spreads is the same as without and if they are
not the equal the return would be created by credit spread arbitrage178 (see Chapter
2.7.2) not by currency carry trading. Furthermore the results are not taking into
account the related fees and transaction costs.
In a first step the return statistic is reported on a quarterly basis for examining the
profit and loss situation during one roll-over period (in this case one quarter).
177
178
- 47 -
Arithmetic mean
Standard deviation
Skewness
Excess kurtosis
Minimum return
Maximum return
Geometric mean
Correlation CHF
Correlation JPY
CHF
-0.01%
2.65%
-1.112
3.789
-10.89%
6.66%
-0.05%
37.86%
JPY
0.38%
6.51%
-0.495
1.520
-23.14%
18.53%
0.17%
37.86%
-
50/50
0.19%
3.95%
-1.082
2.532
-16.06%
9.62%
0.11%
64.72%
95.06%
Figure 20: Quarterly returns and summary statistics on Strategy 1 (Jan. 1990 Oct. 2011)
179
While the CHF returned on average (arithmetic and geometric) slightly below zero,
the JPY exhibits positive returns but with a standard deviation 2.5 times higher than
for CHF. Both currencies show negative skewness (higher in CHF) and excess
kurtosis (also higher in CHF). Benefits of diversification (column 50/50) are hard to
obtain since the arithmetic mean return of the portfolio is half of the JPY (CHF
contributes basically nothing to the return) the portfolio standard deviation is higher
than half of the JPY. Consistent with other findings,180 the portfolio skewness and
excess kurtosis suggest that crash risk can get diversified away through funding with
these two currencies. Supportive for this is, that while the maximum return of the
portfolio (9.6%) is below the arithmetic mean of the single returns (which equals
12.6%) while the average of the two single minimum returns (-17%) is close to the
minimum return of the portfolio (i.e. driven by the collapse of Lehman Brothers,
where JPY faced the worst return and CHF the second worst of the whole series).
Interesting is also the correlation between the returns of JPY and the 50/50 portfolio
which basically exhibits that the portfolio returns are strongly dominated by the JPY.
179
180
- 48 -
Figure 21 exhibits for comparison the other two strategies which are basically
constructed as the first one but shifted for one (Strategy 2) respectively two months
(Strategy 3).
Arithmetic mean
Standard deviation
Skewness
Excess kurtosis
Minimum return
Maximum return
Geometric mean
Correlation CHF
Correlation JPY
CHF
0.00%
2.29%
-0.538
0.956
-8.13%
5.01%
-0.03%
23.49%
Strategy 2
JPY
0.28%
5.92%
-0.542
1.812
-22.97%
13.04%
0.10%
23.49%
-
50/50
0.14%
3.42%
-0.499
1.926
-13.29%
8.37%
0.08%
53.91%
94.53%
CHF
-0.01%
2.48%
-0.652
1.303
-7.50%
5.98%
-0.04%
33.38%
Strategy 3
JPY
0.17%
5.83%
-0.558
0.510
-15.88%
14.29%
-0.01%
33.38%
-
50/50
0.08%
3.53%
-0.726
0.745
-10.72%
6.75%
0.01%
62.71%
94.36%
Figure 21: Quarterly returns and summary statistics on Strategy 2 (Feb. 1990 Nov. 2011) and
181
Strategy 3 (Mar. 1990 Dec. 2011)
Some findings are interesting and therefore worth noting. Starting with the CHF, the
mean returns (arithmetic and geometric) are very close to each other in all three
strategies, what should not be that surprising since the three strategies are almost
completely overlapping (just the shifted start and end for one respectively two months
are different). Skewness and excess kurtosis are lower and also the minimum return
(which is in Strategy 2 generated in the middle of 2010 and in the other two in the
middle of 2011) in both cases is higher than in Strategy 1. Strategy 2 exhibits also a
lower correlation between CHF and JPY compared to the other two strategies. By
looking on the JPY it becomes visible that the mean returns (arithmetic and
geometric) diminish slowly from strategy to strategy and the geometric mean is even
slightly negative in Strategy 3 (whereas the arithmetic mean of 0.17% is positive). In
all three strategies the minimum returns for the JPY carry trade are generated during
the time when Lehman Brothers collapsed, but during this time period Strategy 3
does much better than the other two.
However, since the statistic for each of the three strategies is based on 87
observations and the large spread of results (huge standard deviations compared to
the mean returns) strong arguments against uncovered interest rate parity and
therefore profit opportunities are hard to justify (especially for CHF which exhibits a
point landing on a zero return).
181
- 49 -
Figure 22 depicts the quarterly returns of Strategy 1 for CHF and JPY. It becomes
visible that JPY returns are much more dispersed than CHF returns, which should
not be surprising due to the higher volatility of the exchange rate changes in
EUR/JPY than EUR/CHF (see Chapter 3.2.2 and Chapter 3.2.3).
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
JPY
CHF
Figure 22: Quarterly excess returns CHF and JPY (Strategy 1: Jan. 1990 Oct. 2011)
182
Especially the JPY exhibits some quarters with outstanding positive returns (e.g.
14.3% in 1995 or 18.5% in 2001) but also severe downturns (-13.4% in 1993, -11.6%
in 1997, -12.4% in 1998 and the abysmal drop of 23.1% in 2008). In contrast to the
JPY the CHF does not show that much spikes on a very large scale as JPY does.
Basically the CHF fluctuated around the zero line (positive quarters are followed by
negative ones) until 2002 where a very tranquil period with consistent positive returns
started. However during the recent financial crisis also the EUR/CHF carry trade
generated huge losses during some quarters.
To investigate the result in the long run of both strategies, Figure 23 exhibits
cumulative returns of both the CHF and the JPY for Strategy 1.
182
- 50 -
200
175
150
125
100
75
50
25
0
JPY
CHF
Figure 23: Excess return index CHF and JPY (Strategy 1: Jan. 1990 Oct. 2011)
183
Interestingly, the CHF sticks close to the zero line (at level 100) which basically
means that uncovered interest rate parity holds for the CHF perfectly during this time
(i.e. deviations are small in size and not very persistent). From 2003 onwards the
weakness of the CHF led to a series of positive returns leading the index increase up
to a level of 126 in 2007, but these gains were wiped out by the recent financial crisis
which caused the index to fall below 100. In contrast, the JPY carry trade shows
wider fluctuations around the 100 line until 2002 where it started (similar to the CHF
but on a larger scale) an extended series of positive returns reaching a top of 174 in
2008. Again, a downturn period followed until a level of 116 was reached in October
2011.
Figure 24 plots an overlapping of all three strategies for visualizing the prior provided
summary statistics of the EUR/CHF carry trade. As already seen by the numbers
there is not much difference when the carry trade is started with one or two months
lag, all three seem to provide the same performance.
183
- 51 -
200
175
150
125
100
75
50
25
0
Figure 24: Excess return index CHF (Strategy 1, Strategy 2 and Strategy 3)
184
In contrast the EUR/JPY carry trade, seem to behave different when using shifted
roll-over months (see Figure 25).
200
175
150
125
100
75
50
25
0
Figure 25: Excess return index JPY (Strategy 1, Strategy 2 and Strategy 3)
185
While the first two strategies started positively the third one dropped from the
beginning and remained almost all of the time below the others. While Strategy 1 and
2 ended up positively the third one is slightly negative partially because of the
depreciation of the EUR due to the European sovereign debt crisis in the end of 2011
(Strategy 1 ends on the latest of October 2011 respectively Strategy 2 in November
184
185
- 52 -
2011). Also the tops are interesting since the first strategy peaked at 174 the second
at 164 and the third at 158 which is quite different whereas the index levels prior the
long upward movement (in 2000) and after the correction (in 2008) are quite similar.
Figure 26 shows the cumulative return index on the 50/50 portfolio (for all three
strategies). By comparing the graph with the previous ones of the individual
currencies it becomes evident that in general the movement looks similar to the JPY
graph (see Figure 25) but due to the smooth development of the CHF (see Figure 24)
on a lower scale.
200
175
150
125
100
75
50
25
0
Figure 26: Excess return index 50/50 portfolio (Strategy 1, Strategy 2 and Strategy 3)
186
Figure 27 exhibits the excess return index net of transaction costs, showing a final
result of around 92 for all three strategies instead of roughly 97 under the
circumstance of no fees.
186
- 53 -
200
175
150
125
100
75
50
25
0
Figure 27: Excess return index CHF net of transaction costs (Strategy 1, Strategy 2 and
187
Strategy 3)
Figure 28 provides the cumulative return index net of transaction costs for the JPY
carry trade.
200
175
150
125
100
75
50
25
0
Figure 28: Excess return index JPY net of transaction costs (Strategy 1, Strategy 2 and
188
Strategy 3)
While under the no cost condition all three strategies end up above 100, taking into
account transaction costs lead to final index levels between 110 (Strategy 1) and 95
(Strategy 3).
187
188
- 54 -
Clearly, transaction costs also negatively impact the return of the portfolio strategy
(see Figure 29). Instead of ending up between 110 and 101, the strategies including
transaction costs end up between 105 and 96.
200
175
150
125
100
75
50
25
0
Figure 29: Excess return index 50/50 portfolio net of transaction costs (Strategy 1, Strategy 2
189
and Strategy 3)
However, the continuous rebalancing of the 50/50 portfolio into the target allocation
would generate further switching costs not shown in the graph (depending on the
absolute quantity of the loan, respectively the terms of the loan).
Figure 30 exhibits results on annualized return statistics including the Sharpe ratio
(SR). However due to the large standard deviation compared to mean excess returns
the SR for all three strategies and every single currency are not looking very
attractive.
189
- 55 -
In fact the CHF reports due to the almost zero return also a SR of around zero while
the JPY exhibits a quite attractive excess return at least for the strategies 1 and 2 but
due to the large size of the standard deviation comparable to the mean also a quite
unattractive SR compared to average Sharpe ratios across a wide range of
currencies reported by other empirical studies (e.g. USD based currency carry trades
deliver a SR of 0.44190 or 0.42191). The lack of diversification benefits results also in a
SR for the portfolio which is worse than of the JPY. This stands in contradiction of
studies reporting an increase of the SR through diversifying the carry trade across
multiple currencies (e.g. 0.91192 or 0.89193).
Mean return
Standard
deviation
Sharpe ratio
CHF
-0.04%
Strategy 1
JPY
50/50
1.54% 0.75%
5.30% 13.02%
-0.01
0.12
7.91%
0.09
CHF
0.00%
Strategy 2
JPY
50/50
1.11% 0.55%
4.58% 11.84%
0.00
0.09
6.83%
0.08
CHF
-0.06%
Strategy 3
JPY
50/50
0.66% 0.30%
4.96% 11.66%
-0.01
0.06
7.06%
0.04
194
However, deducting transaction costs of 0.22% p.a. (see Chapter 4.3) from the
reported annualized mean return diminishes the risk reward ratio further down
making the carry trade more unattractive (see Figure 31).
Mean return
Standard
deviation
Sharpe ratio
CHF
-0.26%
Strategy 1
JPY
50/50
1.32% 0.53%
5.30% 13.02%
-0.05
0.10
7.91%
0.07
CHF
-0.22%
Strategy 2
JPY
50/50
0.89% 0.33%
4.58% 11.84%
-0.05
0.08
6.83%
0.05
CHF
-0.28%
Strategy 3
JPY
50/50
0.44% 0.08%
4.96% 11.66%
-0.06
0.04
7.06%
0.01
Figure 31: Annualized return statistics net of transaction costs of Strategy 1, Strategy 2 and
195
Strategy 3
While CHF carry trade returns (after deducting transaction fees) are negative at all
three strategies, JPY retains exhibiting positive returns but the Sharpe ratios became
190
- 56 -
even lower. Also the 50/50 portfolio delivers Sharpe ratios just close to zero, and
would do worse after deducting additional costs for continuous rebalancing.
Figure 32 provides an overview of the absolute debt amount in billion EUR for these
two currencies. One interesting observation is the decrease of outstanding debt
denominated in JPY from 2003 onwards with a simultaneous increase in CHF
denominated one, which provides strong evidence of intense activity in switching the
funding currency during this time period.
bn EUR
60
50
40
30
20
10
0
1998
1999
2000
2001
2002
2003
2004
CHF
2005
2006
JPY
2007
2008
2009
2010
2011
Figure 32: Total CHF and JPY borrowings of Austrian non-monetary financial institutions (Q4
196
1998 Q4 2011)
196
- 57 -
Calculating absolute results (profits and losses) can be done just by a very rough
approximation because for a more accurate calculation, basically dates and foreign
exchange rates of all transactions would be required to examine the correct profit or
loss situation.
In a first step absolute changes of the exposure denominated in EUR are separated
in changes dependent on exchange rate movements (using exchange rates at the
end of each quarter) and real changes coming from either increasing or decreasing
the absolute borrowing amount. Equation 13 shows the calculation basis of the debt
after one quarter, abstracting from exchange rate movements (DebtRealt+1), where
Debtt denotes for the foreign currency exposure reported in EUR at the end of the
previous quarter (Debtt+1 at the end of the current quarter) and St the exchange rate
at the end of last quarter (respectively St+1 the exchange rate for the end of the actual
quarter). The last quarter of 1998 is used as starting exposure.
Using this real debt the gain from the interest rate differential is calculated
according to previous investigations, via the three month LIBOR for foreign currency
borrowing and EURIBOR (respectively VIBOR) for domestic currency lending.
However, results are abstracting from transaction costs and differences in credit
spreads. Both factors would have favoured EUR loans and thus the results derived
show the foreign currency loans more favourable than they actually were.
- 58 -
bn EUR
2.5
1.5
0.5
-0.5
-1.5
-2.5
-3.5
-4.5
1999
2000
2001
2002
2003
2004
2005
Exchange Rate Changes
2006
2007
2008
Interest Rate Differential
2009
2010
2011
Figure 33: Absolute exchange rate changes and interest differential gains on CHF borrowings
197
of Austrian non-monetary financial institutions (Q1 1999 Q4 2011)
Summarized results for the whole time period of CHF borrowings are exchange rate
losses of 12.4 billion EUR and a profit of 6.8 billion EUR coming from lower interest
payments leading to a total loss of 5.6 billion EUR (see Figure 34).
bn EUR
8
4
0
-4
-8
-12
-16
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 34: Cumulative exchange rate changes and interest rate differential profits on CHF
198
borrowings of Austrian non-monetary financial institutions (Q1 1999 Q4 2011)
The JPY reports in contrast to the CHF huge profits between the later 2000 until
beginning of 2003 and comparably small absolute losses caused by the turmoil of the
recent financal crisis (see Figure 35). The reason for the small losses is that the
absolute exposure to JPY borrowings became comparably small after 2003 while
197
198
- 59 -
CHF borrowings increased (i.e. some borrowers switched the funding currency after
very profitable quarters from JPY to CHF).
bn EUR
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
1999
2000
2001
2002
2003
2004
2005
Exchange Rate Changes
2006
2007
2008
Interest Rate Differential
2009
2010
2011
Figure 35: Absolute exchange rate changes and interest differential gains on JPY borrowings
199
of Austrian non-monetary financial institutions (Q1 1999 Q4 2011)
However, JPY borrowers made during the whole timeframe a cumulative exchange
rate profit of 2.4 billion EUR, and gained additionally 3.2 billion EUR through lower
interest payments, summing up to 5.6 billion in total profits (see Figure 36).
bn EUR
7
6
5
4
3
2
1
0
-1
-2
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 36: Cumulative exchange rate changes and interest rate differential gains on JPY
200
borrowings of Austrian non-monetary financial institutions (Q1 1999 Q4 2011)
Figure 37 shows total absolute profits and losses on a quarterly basis of CHF and
JPY borrowings. Worth noting is that in more than 60% of all quarters CHF and JPY
199
200
- 60 -
returns are on the same side (i.e. both made profits respectively both made losses)
which confirms the comovement to some degree of both currencies.
bn EUR
2.5
1.5
0.5
-0.5
-1.5
-2.5
-3.5
-4.5
1999
2000
2001
2002
2003
2004
2005
CHF
2006
JPY
2007
2008
2009
2010
2011
Figure 37: Absolute total profits of CHF and JPY borrowings of Austrian non-monetary
201
financial institutions (Q1 1999 Q4 2011)
In total for the whole timeframe losses made on CHF borrowings and profits on JPY
ones balance each other (i.e. in sum there has been generated neither an advantage
nor a disadvantage through foreign currency borrowing, see Figure 38).
bn EUR
16
12
8
4
0
-4
-8
-12
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 38: Cumulative exchange rate changes and interest rate differential gains on CHF and
202
JPY borrowings of Austrian non-monetary financial institutions (Q1 1999 Q4 2011)
However, there are some severe problems in interpreting the data. First, since the
statistic just reports the debt amount at the end of the quarter using the exchange
201
202
- 61 -
rate at this date is not perfectly valid since transactions are done within the quarter
and exchange rate volatility might skew the results. A second objection is a missing
distinction of borrowers who speculate on lowering their borrowing costs through
foreign currency loans and borrowers with natural interest in holding foreign currency
debt (companies with business relations in the target currencies and private
households with income in foreign currency). And finally the reported numbers
abstract from exhibiting any impact of transaction costs which lower therefore the
absolute profits of private households and also a potential gain from the often raised
argument of lower credit spreads through foreign currency borrowing. However,
besides these concerns, the result gives a rough estimate of the total size of profits
and losses related to foreign currency borrowing in Austria.
bn EUR
50
100%
40
80%
30
60%
20
40%
10
20%
0
2003
0%
2004
2005
2006
2007
2008
2009
2010
2011
Figure 39: Outstanding Austrian private household debt in CHF, absolute (left scale) and
203
relative (right scale) excluding subsector sole proprietors (01.2003 12.2011)
Figure 39 exhibits on the left scale the absolute amount of outstanding debt in
Austrian private households respectively on the right scale the share of private
households on the total outstanding debt denominated in CHF (both excluding sole
203
- 62 -
proprietors). While the absolute size went from 9 billion EUR in 2003 to 28 billion
EUR at the end of 2011 the relative share increased from around 35% to 58%.
bn EUR
10
100%
80%
60%
40%
20%
0
2003
0%
2004
2005
2006
2007
2008
2009
2010
2011
Figure 40: Outstanding Austrian private household debt in JPY, absolute (left scale) and
204
relative (right scale) excluding subsector sole proprietors (01.2003 12.2011)
Including the subsector of sole proprietors boosts the share of CHF debt towards 36
billion or 73% respectively. Doing the same for the JPY, results in an increase of
absolute debt to 2.5 billion EUR, respectively to 67% of all outstanding debt
denominated in JPY.
- 63 -
relative size of Austrian private household borrowings gives an estimate of total gains
from foreign currency borrowing within this debtor segment. However, since missing
data (15 quarters) is replaced by a fixed number instead of not available true one the
following is just a rough approximation of the real profitability.
Figure 41 reports the cumulative gains from interest rate differential and exchange
rate changes plus the sum of the two on Austrian private household borrowings
denominated in CHF. As prior shown for the whole outstanding debt denominated in
CHF, profits from lower interest payments of around 3.8 billion EUR are by far too
small in order to cover exchange rate losses of 7.1 billion EUR, resulting therefore in
a total loss of around 3.2 billion EUR.
bn EUR
6
4
2
0
-2
-4
-6
-8
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 41: Cumulative exchange rate changes and interest rate differential gains on CHF
205
borrowings of Austrian private households (Q1 1999 Q4 2011)
Equivalent to the CHF borrowings, Figure 42 exhibits the profits of JPY loans. In
contrast to the reported numbers on debt denominated in CHF, JPY borrowers
generated also a positive result from exchange rate changes (1.1 billion EUR).
Adding this to gains around 1.5 billion EUR due to lower interest rate expenses, lead
to a total cumulative profit of around 2.6 billion EUR.
205
- 64 -
bn EUR
4
3
2
1
0
-1
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 42: Cumulative exchange rate changes and interest differential gains on JPY
206
borrowings of Austrian private households (Q1 1999 Q4 2011)
bn EUR
8
6
4
2
0
-2
-4
-6
-8
1999
2000
2001
2002
2003
2004
Interest Rate Differential
2005
2006
2007
2008
Exchange Rate Changes
2009
2010
Total
2011
Figure 43: Cumulative profits of CHF and JPY borrowings of Austrian private households (Q1
207
1999 Q4 2011)
206
207
- 65 -
Suppose a private household takes a foreign currency loan for buying a house. But
instead of continuous repay the debt during the lifetime, the borrower decides to
invest the redundant money into an investment product. Hence, the private
household pays just the interest on the loan and an additional amount into a savings
plan. At maturity of the loan, the investment product gets liquidated in order to repay
the outstanding debt amount. However, this approach only makes sense (in terms of
increasing the private household wealth) if the return on the investment product is
expected to be higher than the interest expenses on the loan.
Equation 14 shows the calculation of the total periodical payments where the first
fraction accounts for the interest expenses on the loan and the second one for the
annuity payment on the repayment vehicle in order to achieve the target value (loan
amount) at the end of the loan lifetime. CEUR denotes the required amount in EUR, St
stands for the exchange rate at the moment of taking out the loan (respectively S t+T
for the exchange rate at the moment of the loan repayment), iFCU is the foreign
currency lending rate, iEUR the domestic investment return and T the number of
periods.
Equation 14: Constant payments for a balloon loan including a repayment vehicle
The following numerical example is based on the same exemplary numbers from the
previous section. Given is an interest rate on the foreign currency loan of 2.5% and a
fixed foreign currency exchange rate. In addition the private household has the
opportunity to invest money riskless at 4% in domestic currency and does not face
any fees or income taxes. The lifetime of the loan is 25 years and all payments are
- 66 -
done quarterly. Instead of continuous annuity payments in order to pay back the loan,
the private household makes only periodical interest payments on the loan. Beyond
these interest payments the private household makes additional payments into the
investment product generating 4% return via a savings plan.
However, if all interest rates like in this example are fixed and there is no exchange
rate risk or counterparty risk involved, this condition provides an arbitrage opportunity
(except for a peso problem as described in Chapter 3.5.5). An arbitrageur would lend
as much as possible at 2.5% in foreign currency in order to invest the proceeds
domestically.
However, in contrast to professional arbitrageurs who invest the borrowings from low
yielding currencies directly in high yield ones, the described private household uses
in a first step the proceeds for buying a house instead of immediately investing the
money at 4% into the domestic fixed income market. The arbitrage strategy is
implemented since payments into a savings plan replace the continuous ordinary
loan repayment.
208
cf. p. 33
- 67 -
loan is open to 100% until repayment. Therefore Figure 44 provides the net exposure
of the balloon loan (i.e. loan minus current value of the repayment vehicle).
0%
0
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
-25%
-50%
-75%
-100%
Domestic Currency
Foreign Currency
Balloon Loan
Figure 44: Outstanding debt comparison of balloon loan versus standard domestic and foreign
209
currency borrowing
While the domestic currency loan gets repaid in 25 years and the foreign currency
counterpart in 20 years,210 the balloon loan is already repaid in around 18 years.
However, even if the loan can get repaid within 18 years the rational would be not to
liquidate the repayment vehicle for covering the debt. The reason is, that after these
18 years the value of the repayment vehicle reaches the outstanding debt amount,
hence the household has to pay no additional money into the repayment vehicle and
generates the positive differential between the investment return on the one hand
and interest expenses of the loan the on the other. However, if this condition existed
in reality the private household would generate the highest payoff if the loan would
never get paid back. Furthermore it would be rational for the borrower to lever up as
much as possible, i.e. taking the highest possible debt amount in order to invest
proceeds immediately into the investment product besides the payments through the
savings plan. Otherwise, if private households and their financial advisors really
believe on positive returns through investing borrowed money, constructing a loan
with a fixed repayment date, is irrational (except if the lender set constraints).
In-deed there is evidence that in real world financial advisors often told private
household customers to take a higher loan than required in order to invest
immediately into a savings product.211 However as prior shown, most outstanding
209
authors calculations
cf. p. 35
211
cf. Kowatsch (2003): p. 26, translation by the author
210
- 68 -
balloon loans with repayment vehicle mature between the years 2025 and 2030,212
and substantial debt amounts of similar size have to be repaid 5 to 10 years before
and after (see Figure 5). Even though most borrowers have the opportunity to switch
the funding currency respectively liquidate the repayment vehicle, using investment
products with equal maturity than the foreign currency loan (e.g. life insurances)
exhibit that borrowers are at least expecting to hold the balloon loan construction until
maturity. The only rational between this would be, when some borrowers expect
positive returns from this construction from taking out the loan until the year 2015,
some until 2020 and so on and so forth. A more likely explanation might be that
borrowers decided on maturities depended on the size of monthly payments as they
do for ordinary domestic currency loans as well. In this case borrowers act irrational,
since they leave the payoffs of the arbitrage opportunity (if borrowers really believe
in) after the loan maturity on the table.
The first two bars show the interest rates for borrowing, which are under domestic
currency basically the sum of the domestic risk-free rate (exemplary 3%) plus the
credit spread (1%) while foreign currency borrowing comes with a risk-free rate of
212
cf. p. 5
- 69 -
1.5% plus equal credit spread of 1% and an additional impact due to transaction
costs of 0.25%. However, if there are no exchange rate changes, foreign currency
borrowing gives an advantage due to the lower all-in interest rate (1.25% less than
domestic currency denominated borrowing) making therefore borrowing substitution
attractive. Since the basic idea is to borrow in FCU in order to invest in one of the
three named major asset classes, the focus is to compare the costs of borrowing in
FCU and the investment returns. Investment gross returns get lowered by fees
(0.25% for money market funds, 0.5% for long term bond funds and 1.5% for equity
funds) and capital gains tax (25% of the gross return).
8%
7%
Fees
6%
Equity
Premium
5%
4%
3%
2%
1%
Credit
Spread
Risk
Free
Transaction
Costs
Credit
Spread
Risk
Free
Taxes
Fees
Maturity
Premium
Taxes
Risk
Free
Net
Return
Risk
Free
Long Term
Bonds
Long Term
Bond Fund
Equities
Fees
Taxes
Risk
Free
Net
Return
Net
Return
0%
EUR
Borrowing
FCU
Borrowing
Figure 45: Comparison of interest rates between borrowing and investment returns
Equity Fund
213
The exemplary numbers show, that even if the foreign risk-free rate is below the
domestic one and exchange rates are stable (i.e. violation of uncovered interest rate
parity) the all-in rate for foreign currency borrowing is equal to the domestic risk-free
rate and even higher than the speculators money market net return (see the bar of
the Money Market Fund). The reason is that the received return gets lowered through
fees and taxes. Comparing borrowing to long term bonds show a positive interest
rate differential which also gets slightly negative after fees and taxes on the
investment product. Remains the equity market for investing, exhibiting a gross
return more than two times as high as borrowing costs are. After deducting fees and
taxes even equities do not provide a large spread over borrowing costs.
213
authors calculations
- 70 -
However, reality shows even higher fees on investment products, especially for
active management, than assumed in the example. On the other hand, equity returns
might have a lower marginal tax rate in practice.
Concluding remarks are, even when numbers are just created artificially the point is
that gross investment returns have to be substantially (in the example more than two
times) higher than borrowing costs to justify a FCU balloon loan.
Equation 15: Private household portfolio including foreign currency borrowing (balloon loan)
with a repayment vehicle
The portfolio volatility is even higher than just using foreign currency borrowing
because the value fluctuates due to exchange rate movements and the market value
of the repayment vehicle as well (except when the two are perfectly correlated).
Furthermore, since debt does not get repaid continuously and is therefore open with
100% during the whole loan lifetime, exchange rate movements constantly have a
high impact on the portfolio value. This holds especially when the repayment vehicle
is denominated in domestic currency which might depreciate sharply under domestic
financial market turmoil. Hence, by contrast to a continuous repaid foreign currency
loan, the balloon loan construction including a repayment vehicle has a levered
exposure to this risk (but provides also levered returns, which is the basic idea of the
borrower behind this construction).
currency for buying a house). The lower filled area shows the short position of the
borrowed amount (short FCU), which does not get repaid (i.e. in contrast, the
exposure of an ordinary loan would get lowered during the lifetime). The upper filled
area (long position) exhibits the value of the repayment vehicle, which can be
denominated in domestic (EUR) or another foreign currency (FCU). However, since
there is no continuous repayment, the borrower faces a short position of the total
exposure in foreign currency at 100% over the whole loan lifetime. The long side
consists of the implicit investment in EUR (the substituted EUR loan) and the value
of the repayment vehicle. Therefore the filled area exhibits is basically the investment
of borrowed money which gets larger over time while the share of borrowing
substitution (shaded area) gets smaller. The final position is an open loan amount
which is in total covered by the repayment vehicle (i.e. the borrower uses at this point
in time the whole loan amount for the investment product, not for housing).
100%
EUR (FCU)
50%
EUR
0%
0
FCU
25
-50%
-100%
FCU
Figure 46: Long/Short diagram of foreign currency borrowing including a repayment vehicle
214
However, the investment currency could also be another foreign currency or even the
funding currency. If investing and funding currency are equal, the repayment vehicle
does not generate an additional carry trade return. Therefore the strategy is based on
the expectation of higher maturity or equity risk premiums abroad than domestically.
However, this strategy is not constraint to low yielding currencies (i.e. high yielding
currencies can offer higher maturity or equity premiums as well). Therefore the
behaviour of focusing only on classical funding currencies as CHF and JPY might
show financial illiteracy of the borrower.
Using a third currency to invest in, adds a further dimension, which increases the
overall complexity. Besides the forecast of lowering the loan expenses through
214
authors calculations
- 72 -
In general banks charge credit spreads between 0.5% and 2% over the LIBOR, most
common by between 1.25% and 1.75%.215 Furthermore, this spread is charged on an
interbank rate and not on the risk-free rate. Hence, the borrowing interest rate
includes also the spread between the respective risk-free rate (Treasury bills) and the
interbank interest rate (LIBOR) most well known in this field is the TED spread.
Equation 16: Internal rate of return on a balloon loan including transaction costs
The following calculation uses the same exemplary numbers obtained from real world
foreign currency loan offers as investigated in Chapter 4.3. These costs are a bid-ask
spread of 1% (SAsk of 1.005, respectively SBid 0.995), each quarter 15 EUR for the
215
- 73 -
clearing account (FEUR), a transaction fee of 0.275% (f) and the additional land
register tax of 360 EUR (LEUR). The EUR amount required by the borrower (CEUR) is
150,000.
Figure 47 exhibits results on the transaction cost impact on a balloon loan. Due to the
different structure of payments the impact on the internal rate of return is lower for a
balloon loan (0.16%) compared to a continuous repaid loan of equal size (0.22%).
incl. fees
EUR
bid-ask
F
excl.
fees
ALL
2.50%
2.66%
2.57%
2.54%
2.54%
2,52%
0.16%
0.07%
0.04%
0.04%
0.02%
EUR
216
For obtaining the typical investment products used as repayment vehicles for a
foreign currency balloon loan, a survey among financial advisors shows that 62.2% of
the money is invested in variable life insurances, 11.6% in guarantee funds, 11% in
equity funds and 7.5% funds of funds.217
Costs of variable life insurances are between 1% and 2% per year just for the
insurance shell plus additional costs on the underlying fund (management fees,
transaction costs) which are usually higher than the costs charged by the insurance
company itself.218
Classical endowment life insurances returned in the past around the secondary
market yield.219 As rule of thumb one can subtract 1.5% of these reported returns due
216
authors calculations
cf. Cocca 2010: p. 22, translation by the author
218
cf. Hager/Kreindl 2012: p. 65, translation by the author
219
cf. Hager/Kreindl 2012: p. 77, translation by the author
217
- 74 -
to fees and taxes.220 Because of new regulations (Solvency II) these returns might
become even lower in the future. 221
The costs for mutual funds are dependent on the underlying asset class (often
referred as riskiness of the fund). US-based studies show an average total expense
ratio of money market funds of 0.7%, bond funds of 1% and equity funds of 1.5%.222
However, besides these costs brokerage commissions, spread costs and tax costs
occur in comparable size to the expense ratio.223
However, an often risen argument is that active management justifies these high
costs with outperformance over the market. Empirically, index funds generate
consistent by a return 2 percent points higher than active management for the reason
of management fees and trading costs.224 Since all market participants on average
generate the market return, active management has almost inevitably to produces
lower returns than the market even when markets are not efficient.225
History shows that the total costs of mutual funds have risen over time. While
between 1945 and 1965 the average equity fund delivered a return 1.7 percent points
lower than the average stock market return (mutual fund holders generated 89% of
the equity return) the timeframe from 1983 until 2003 exhibits a return 2.7 percent
points below the average market (mutual fund holders generated just 79% of the
equity return).226
Mutual funds in Austria typically charge between 0.4% and 2% per year in
management fees dependent on the volume and riskiness of the invested amount.227
In addition usual front-end loads on mutual funds are between 2% and 5.5% in high
risk asset classes, respectively 1% and 3.5% for medium and 0.5 and 2.5% for low
risk products.228 In addition a fee between 0.1% and 0.5% per year for the deposit
220
- 75 -
account of the securities is charged. 229 However, transaction costs, expense ratios,
sales charges and financial advisory fees sum up to a substantial hurdle in capturing
stock market returns.230
Apart from all these fees taxes also lower substantially investment gross returns. In
general, coupons on bonds and stock dividends are for Austrian private households
charged with 25% withholding tax.231 Life insurances are excepted from this but
therefore charged with 4% insurance premium tax (i.e. 4% on the insurance
premium).232 The taxation of capital gains is dependent on the purchasing date of the
investment product. Under the new tax regulation the difference between the sales
and purchasing price of bonds, stocks and derivative products are charged with 25%
with exceptions for repayment vehicles of balloon loans.233
However, in addition of the reported carry trade return between EUR and CHF,
respectively JPY, a foreign currency borrower has the opportunity to invest the
money into a classical investment currency (e.g. AUD or NZD) generating therefore
returns closer to comparable carry trade returns. Deducting the credit spread and all
other costs and taxes investing borrowings from a foreign currency private household
loan into the money market might presumable not generate a positive return.
229
- 76 -
However, using some kind of derivative product, respectively index funds on the
carry trade strategy, might offer cheaper opportunities to speculate on the invalidity of
uncovered interest parity than using borrowings from an ordinary private household
foreign currency loan.
However, foreign currency borrowers can also invest in the funding currency with the
idea of lowering the exchange rate risk. But this construction does not offer the
additional currency carry trade return. The expectation is simply a higher term spread
in foreign currency than under domestic currency. Because otherwise a borrower can
use domestic currency borrowings with a short term interest rate for investing into
domestic currency long term bonds.
Talking correctly, the term spread is the difference between 90 days treasury bills
and long term government bonds. However, since the return is generated by funding
for LIBOR the following exhibits the yield spread between the 3 month funding rate
and uses for investment a 10 year government bond of the respective country.
Therefore the difference is called intermediation spread since the maturity premium
is abstracted by the theoretic equivalent of the TED spread in each of the
investigated countries.
Figure 48 shows the Austrian intermediation spread of lending for the 3 month short
term rate (flat) and investing in 10 year government bonds. With the exception of a
short negative period (during the recent financial crisis) the spread fluctuated
between 0% and 3.5%.
- 77 -
5%
4%
3%
2%
1%
0%
-1%
-2%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Figure 48: Intermediation spread between 10 year Austrian government bond yield and 3 month
234
EURIBOR (VIBOR before 1999, 01.02.1994 15.11.2011)
5%
4%
3%
2%
1%
0%
-1%
-2%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
JPY
CHF
Figure 49: Intermediation spread between 10 year Swiss and Japanese government bond yield
235
and 3 month CHF respectively JPY LIBOR (01.02.1994 15.11.2011)
234
235
- 78 -
Mean
Standard deviation
EUR
1.60%
0.97%
CHF
1.35%
0.68%
JPY
1.64%
0.89%
Figure 50: Intermediation spread between 10 year government bond yield and 3 month
236
interbank rate
What also turns out is, that while borrowing in CHF and JPY in order to invest in
Austrian government bonds generates (apart from the term spread) potential returns
from currency carry trading, the latter return source is not existing under financing in
CHF respectively JPY in order to invest in Swiss respectively Japanese government
bonds. What the table also makes clear, that a maturity intermediation in these two
foreign countries will hardly be profitable, since the reported mean has to cover the
credit spread, transaction fees and taxes. Furthermore the table exhibits that the
yield curve is on average not steeper in these two foreign countries, meaning that
funding and investing in foreign currency (CHF and JPY) does not generate higher
returns than funding and investing in EUR.
Also in the long run (between 1900 and 2010) the maturity spread does not show a
more promising picture. While in Switzerland bills offered 3.1% and bonds 4.5%, 237 in
Japan the difference was even smaller (bills 5% and bonds 5.8%). 238 In a global
diversified portfolio during these 111 years bills returned nominal by 3.9% and bonds
4.7%.239 Overall, history shows that the difference between short term bills and long
term bonds might be too narrow to cover credit spreads and costs which private
households have to face when trying to implement maturity intermediation.
236
- 79 -
Historically the US equity risk premium for 200 years (separating the timeframe into
three sub-periods) was 1.9% in the first period (1802 1871), 3.4% in the second
one (1871 1925) and 6.5% in the third one (1926 2001).240 Especially the last of
the three sub-periods exhibited an outstanding return over the risk-free rate. It should
not be taken for granted that this will stay the same in the future as the dismal
years between 2001 and 2012 have shown.
Within the years 1900 until 2010 equities in 19 investigated countries, representing
83% of world equity market,241 returned on average 3.8 percent points over long term
government bonds whereas during 2000 and 2010 the equity risk premium was on
average negative (minus 3.2%).242 Switzerland offered a premium above bills of 3.4%
over 111 years (1900 2010) and 4.1% during the last 25 years (1986 2011).243
Japanese equities offered an excess return of 5.9% during 111 years and -1.7%
within the last 25 year period.244 The world index offered an equity risk premium
above US Treasury bills of 4.5% during 111 years and the same within the 25 year
timeframe.245
However, due to the scope of diversification, the risk for investors went down
providing strong evidence, that the equity risk premium is expected to be lower in the
future than in the past, resulting to an estimated risk premium above Treasury bills
between 3% and 3.5% (geometric mean) respectively 4.5% and 5% (arithmetic
mean).246
- 80 -
same basis in order to keep consistency. However, geometric mean returns are
reported as well. Equation 17 exhibits the calculation approach.
While the first part of the equation is basically the carry trade return obtained in
Chapter 4.5.1 the second part adds the premium coming from stock market
investments (i.e. excess return of equities over the domestic short term interbank
interest rate). In addition to the already denoted variables, Pt stands for the stock
market index level at time t respectively Pt+1 for the index level at time t+1. According
to the prior chapter, as domestic interbank rate the three month EURIBOR
(respectively VIBOR prior 1999) is used.
The stock market index levels are obtained by the MSCI World Index (gross return,
i.e. reinvestment of gross dividends). However, calculations of excess returns net of
costs (see Chapter 5.6.3) are based on the MSCI World Index net return (i.e.
reinvestment of net dividends after tax deduction).
The calculation is done in the same way as for the carry trade return in Chapter 4.5
(quarterly basis, three strategies). Strategy 1 starts at the last of January 1990 until
the last of October 2011, Strategy 2 starts on February 1990 until November 2011
and finally Strategy 3 from March 1990 until December 2011.
- 81 -
Arithmetic mean
Standard deviation
Skewness
Excess kurtosis
Minimum return
Maximum return
Geometric mean
Strategy 1
CHF
JPY
0.60%
0.99%
9.80%
10.05%
-0.331
-1.252
0.040
2.813
-26.08%
-40.24%
21.98%
16.04%
0.11%
0.44%
Strategy 2
CHF
JPY
0.70%
0.98%
9.72%
9.66%
-0.527
-1.376
0.100
6.774
-28.39%
-47.75%
21.63%
27.23%
0.22%
0.45%
Strategy 3
CHF
JPY
0.85%
1.03%
10.15%
10.14%
-0.733
-1.144
0.524
2.190
-27.68%
-36.90%
20.28%
21.40%
0.31%
0.47%
Figure 51: Quarterly MSCI World gross excess return statistics of Strategy 1, Strategy 2 and
247
Strategy 3 (funded via 3 month CHF respectively JPY LIBOR)
Figure 52 exhibits the annualized summary statistics including the Sharpe ratio of
each strategy. However, mean returns are annualized through compounding and
standard deviation through multiplying with the square root of four according to the
square root of time rule.
Arithmetic mean
Standard deviation
Sharpe ratio
Strategy 1
CHF
JPY
2.43%
4.03%
19.61%
20.10%
0.12
0.20
Strategy 2
CHF
JPY
2.83%
3.97%
19.44%
19.32%
0.15
0.21
Strategy 3
CHF
JPY
3.43%
4.17%
20.30%
20.29%
0.17
0.21
248
In sum the CHF funded construction generated an annual arithmetic mean return
depending on the strategy between 2.4% and 3.4% while JPY funded investments
returned around 4%. However, Sharpe ratios between 0.12 and 0.21 depending on
the currency and strategy do not show a very attractive risk-reward profile. This even
more, as the reported mean returns have to cover the credit spread, taxes and fees
as well.
Figure 53 provides graphically the CHF funded excess return index (above 3 month
EURIBOR) for all three strategies. The index reached a top of roughly 250 in 2000
ending in 2011 on a level of around 120.
247
248
- 82 -
350
300
250
200
150
100
50
0
Figure 53: Excess return index on a CHF funded investment into MSCI World Gross Index
249
(Strategy 1, Strategy 2 and Strategy 3)
Equivalent, Figure 54 shows the excess return index for JPY funded MSCI World
investments. The weakness of JPY boosted the index level up to around 320 in 2007.
However, the recent financial crisis caused also a strong correction on the index
level, ending at approximately 150 in 2011.
350
300
250
200
150
100
50
0
Figure 54: Excess return index on a JPY funded investment into MSCI World Gross Index
250
(Strategy 1, Strategy 2 and Strategy 3)
249
250
- 83 -
Figure 55 shows the quarterly returns after deducting costs and taxes on the
dividend. Even when arithmetic means are slightly positive at least for JPY in all
three strategies, geometric means are negative for both currencies in all three
strategies.
Arithmetic mean
Standard deviation
Skewness
Excess kurtosis
Minimum return
Maximum return
Geometric mean
Strategy 1
CHF
JPY
-0.31%
0.08%
9.80%
10.04%
-0.331
-1.254
0.039
2.816
-26.98%
-41.15%
21.03%
15.16%
-0.80%
-0.48%
Strategy 2
CHF
JPY
-0.21%
0.06%
9.71%
9.65%
-0.530
-1.384
0.098
6.786
-29.29%
-48.66%
20.53%
26.13%
-0.70%
-0.46%
Strategy 3
CHF
JPY
-0.07%
0.11%
10.15%
10.14%
-0.733
-1.147
0.524
2.196
-28.59%
-37.82%
19.37%
20.48%
-0.61%
-0.45%
Figure 55: Quarterly MSCI World net excess return statistics of Strategy 1, Strategy 2 and
252
Strategy 3 net of costs (funded via 3 month CHF respectively JPY LIBOR)
251
252
- 84 -
Figure 56 exhibits the annualized returns and standard deviations as well as the
Sharpe ratios after deducting the credit spread, fees and taxes. In contrast to the
idealistic world, where borrowing at the flat interbank rate is possible and investing is
free of fees and taxes, the returns under realistic assumptions does not show very
promising results. Even when mean returns are positive (at least for the JPY funded
investment) Sharpe ratios of around zero illustrate the unattractiveness in terms of
risk to reward of these strategies.
Arithmetic mean
Standard deviation
Sharpe ratio
Strategy 1
CHF
JPY
-1.24%
0.32%
19.60%
20.09%
-0.06
0.02
Strategy 2
CHF
JPY
-0.85%
0.26%
19.42%
19.30%
-0.04
0.01
Strategy 3
CHF
JPY
-0.27%
0.45%
20.29%
20.28%
-0.01
0.02
Figure 56: Annualized return statistics net of transaction costs of Strategy 1, Strategy 2 and
253
Strategy 3
Figure 57 exhibits the excess return index of CHF funded MSCI World index
investments net of costs, ending at 54 after 87 quarters.
350
300
250
200
150
100
50
0
Figure 57: Excess return index on a CHF funded investment into MSCI World net of taxes,
254
credit spreads and transaction costs (Strategy 1, Strategy 2 and Strategy 3)
Equivalent, Figure 58 shows cumulative JPY funded MSCI World return index ending
in 2011 on index levels for all three strategies of around 67.
253
254
- 85 -
350
300
250
200
150
100
50
0
Figure 58: Excess return index on a JPY funded investment into MSCI World net of taxes, credit
255
spreads and transaction costs (Strategy 1, Strategy 2 and Strategy 3)
The two graphs basically tell that investing in a worldwide diversified portfolio of
equities funded via CHF or JPY loans has performed very poor after deducting for
costs and taxes during the last 22 years (87 quarters).
The comparison between gross and net returns exhibits how substantial cumulative
costs can lower even potential attractive looking speculative returns.
255
- 86 -
6 Principal-Agent Relationships
6.1 Principal-Agent Relationship in Private Household Borrowing
The following part describes how conflicts of interest between a principal (client) and
an agent (financial advisor) influence the implementation of foreign currency loans.
This might lead to poor results even when the borrowing in another than domestic
currency would really be profitable.
As foreign currency borrowing and here especially the balloon loan construction
including a repayment vehicle is a very complex product, it is very likely that private
households interested in foreign currency borrowing rely on recommendations of
financial advisors.
However, using financial advice for the decision making process might have to deal
with a conflict when interests of the client (foreign currency borrower) and the
information provider (financial advisor) are not aligned. A classic example is, a
conflict of interest caused by the compensation scheme of the financial advisor. The
common way of paying for financial advice either by independent financial advisors
or bank advisors is commission based. In such an environment the natural interest of
the client (maximizing welfare) may conflict with the interest of the advisor
(maximizing profits via commissions). Furthermore, the financial advice might contain
biased information in order to drive the clients decision towards a specific direction
(i.e. buying a specific product which contains the highest commission for the advisor).
Supportive therefore, a poll among the EU members of the CFA Institute shows that
256
257
cf. European Opinion Research Group EEIG 2004: p. 152, translation by the author
cf. European Opinion Research Group EEIG 2004: p. 152, translation by the author
- 87 -
64% of respondents agreed that the fee structure of the investment products drive
their sales process stronger than the suitability for their customers.258
Evidence also shows, that some bank advisors and independent financial advisors
recommend their customers to liquidate life insurances in order to buy a new
repayment vehicle paying therefore to the advisor a huge commission as well. 260 The
existence of biases in advice due to commissions gets supported by a study showing
that customers using financial advisors have on average a higher turnover ratio than
not advised portfolios and therefore higher trading costs (leading to higher
commissions for the advisors).261
258
- 88 -
262
- 89 -
Great Britain.270 Or stock listed real estate shares which have been sold very actively
through financial advisors, charging therefore front end loads and maintenance
commissions as typical for mutual funds.271 Some of these stocks have been sold
with a commission of 16%.272
Besides this incentive conflict, foreign currency borrowers might face a problem due
to selective information gathering through financial advisors. The reason is that if
financial advisors hold foreign currency loans for themselves, the advice might get
biased by the overoptimistic prospect of the advisor. Survey respondents show that
financial advisors holding a foreign currency loan on their own have on average 84
customers using foreign currency borrowing (of on average total 414 customers)
while financial advisors without using foreign currency for themselves have on
average just 17 foreign currency borrowing customers (of total 309 customers).273
- 90 -
currency balloon loans as well. The reason is that on the one hand the bank
generates interest income from the nominal loan amount during the whole lifetime
(which is different to conventional loans, since the outstanding amount decreases
during the lifetime) and gets additional high commissions on the repayment vehicle.
Especially selling in-house investment products as investment vehicle substantially
increases the overall profitability of the financial institution, because profit is made on
each step of the supply chain.
Bank advisors might also get forced by the bank management not to sell foreign
currency loans actively, i.e. push the sales force to prefer conventional loans in the
sales process for internal reasons (e.g. higher profits on conventional loans, reducing
reputational risk, to avoid the currency mismatch, etc.). Such biased advice is also
unfavourable to clients, if foreign currency borrowing would be more suitable to them.
Especially when refinancing costs increase, respectively refinancing gets difficult as
seen during the recent financial crisis, bank advisors might get forced to recommend
clients to unwind their foreign currency loans in order to switch in EUR (where the
lending bank can refinance with savings deposits).
However, the reputational risk from mis-selling by bank advisors exceeds by far the
respective risk with independent financial advisors, since some Austrian banks have
existed for more than a century and face therefore the risk to lose a huge brand
value. This might also partly explain the more carefully sales approach by bank
advisors as found in some studies respectively.
- 91 -
7 Concluding Remarks
7.1 Conclusion on the Empirical Findings
Foreign currency borrowing plays a substantial role in Austrian private households 277
which is very different from the average private household debt within the European
Monetary Union.278 In contrast to conventional domestic currency loans, foreign
currency ones are mostly constructed as balloon loans including a repayment
vehicle.279 CHF and JPY together account for almost 100% of foreign currency
loans.280 Herding behaviour and supply driven factors as the activity of independent
financial advisors deliver potential explanations this behaviour.281
The basic idea behind foreign currency borrowing as substitute for a conventional
domestic currency loan is lowering total borrowing expenses. Profits are generated
either through lower interest expenses, exchange rate profits or a sum of both.
Foreign currency denominated borrowing in Austrian private households has been
focused almost only on CHF and JPY,282 which have exhibited since 1990 nearly
uninterrupted lower interest rates than the domestic equivalent one.283 This shows
that private households have presumable purely based their speculation on the lower
interest level not on exchange rate movements, a strategy called currency carry
trading.
According to the theory of uncovered interest rate parity, any positive gain from the
interest rate differential should be erased by exchange rate movements in the same
size (i.e. an expected forward market return of zero on average).
Empirical investigations show, that this currency carry trade strategy is able to deliver
quite attractive risk-adjusted returns but also substantial downside risks. 284 A unifying
and satisfying explanation on the forward puzzle and related carry trade returns does
not seem to have been found yet.
277
cf. p. 4
cf. p. 7
279
cf. p. 5
280
cf. p. 5
281
cf. pp. 9 12
282
cf. p. 5
283
cf. pp. 17 20
284
cf. pp. 28 31
278
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Statistics abstracting from transaction costs show that CHF offered quarterly payoffs
(arithmetic and geometric means) of almost zero while JPY exhibits positive means
(arithmetic between 0.17% and 0.38% respectively geometric -0.01 and 0.17%).285
However, costs related to foreign currency borrowing negatively impact the payoff to
private households. The internal rate of return of an artificially created loan based on
real market conditions increases by 0.22% on a conventional repaid loan,286
respectively 0.16% on a balloon one.287
Sharpe ratios before and after transaction costs are slight below zero for CHF
borrowings and around 0.09 before and 0.07 after currency related costs for JPY (i.e.
both exhibit a very unattractive risk-reward profile of foreign currency borrowing).288
Portfolios funded half in CHF and half in JPY exhibit lower Sharpe ratios than 100%
JPY funded ones (i.e. there has been no benefit of diversification through using both
currencies equally weighted for funding).289
The reason for the small excess return compared to empirical studies on the
currency carry trading strategy might be that the EUR is not a classical investment
currency. While CHF and JPY are classical funding currencies, an Austrian private
household generates returns only through low-yield funding (and misses high-yield
investment returns) since the implicit long side is constraint to the substituted EUR
loan. In contrast an Australian borrower (AUD is a classic investment currency) using
a CHF or JPY loan receives due to the higher interest rate differential a return much
closer to carry trade returns reported in the literature.
285
cf. pp. 48 49
cf. p. 41
287
cf. p. 74
288
cf. p. 56
289
cf. p. 56
290
cf. p. 59
286
- 93 -
zero sum game).291 Focusing on private households only results in a total cumulative
loss (both currencies) of 0.7 billion EUR.292 Since these results are valid for the
community of Austrian foreign currency borrowers, there is a huge variety of returns
to the individual borrower (i.e. very profitable for some and substantial losses for
others).
There is strong evidence that the huge payoffs on JPY borrowings are windfall
profits. At least, in the ex post view, Austrian non-financial borrowers have
successfully speculated with a huge increase of loans against JPY. But due to their
huge downshift of outstanding JPY debt around 2003, and the following weakness of
JPY against EUR, borrowers missed to generate substantial profits in the following
years. However, from the viewpoint of 2003 without knowing the future, borrowers
may have acted according to the saying a bird in the hand is worth two in the bush.
The big increase in CHF denominated debt from 2002 onwards is quite interesting,
since interest differential profits have been erased by exchange rate losses
continuously between 1990 until 2003. Surprisingly after the huge increase of CHF
short positions by Austrian non-financial institutions, currency carry trades between
EUR funded in CHF became profitable until 2007. However, the financial crisis
needed less than three years to turn the maximum cumulative profit negative.
This findings lead to the conclusion that within this investigated period, substituting
domestic currency borrowing by a CHF and JPY one has not offered an attractive
opportunity to the community of Austrian private households neither in absolute
numbers and even less on a risk-adjusted basis.
Since most loans are balloon loans plus repayment vehicle, the profitability on this
construction is important as well. Findings show that in 2009 75% of repayment
vehicles have been directly exposed to market risk. 293 Therefore the profitability is
assessed through MSCI World investments funded by borrowings in CHF and JPY.
Returns are calculated equivalent to carry trade returns on quarterly basis for the
period between 1990 and 2011.
291
cf. pp. 60 61
cf. p. 65
293
cf. FMA 2010: p. 4, translation by the author
292
- 94 -
Abstracting from all frictions (i.e. no fees and taxes respectively lending for the riskfree rate), arithmetic and geometric means are positive in all cases for both
currencies.294 However, Sharpe ratios of around 0.15 for CHF funded investments
respectively 0.2 for JPY ones are not very attractive.295
Including costs and taxes into the calculation, lead to negative arithmetic and
geometric returns for CHF, and positive arithmetic respectively negative geometric
results for JPY funded investments.296 During the worst quarter, borrowers faced
substantial losses of -29% (CHF) respectively -49% (JPY).297 Sharpe ratios are
almost zero as well (slight negative for CHF respectively slight positive for JPY both
to a negligible extent).298 Within the investigated 87 quarters, speculators
cumulatively lost nearly half of their capital via CHF funded MSCI World investments
respectively one third when they used JPY as funding currency.299
cf. p. 82
cf. p. 82
296
cf. p. 84
297
cf. p. 84
298
cf. p. 85
299
cf. pp. 85 86
300
cf. Keynes 1964: p. 157
295
- 95 -
Further knowledge on the nature of repayment vehicles would help to judge the
profitability of the balloon loan strategy. Also the behaviour of private households in
switching the funding currency for realizing profits and losses would help to answer
the payoffs in real world. Even when there is a lot of evidence against the argument
of lower credit spreads on foreign currency borrowing, further investigations
regarding market segmentation respectively price discrimination through currency
denomination would give useful insights.
301
302
- 96 -
more debt for buying a bigger house, which leads to a higher exposure on the real
estate market instead of higher financial flexibility.303
There is also evidence that a number of private households increased their debt in
order to invest the borrowed excess money directly into a repayment vehicle.
Investigations in this would shed light into the general risk taking behaviour of such
individuals.
Taking a closer look into the effect of media reporting and the role of independent
financial advisors on the borrowing behaviour would open an attractive field for future
research. However, even when conventional media distribute ideas very effective,
investment decisions are dominated by personal communication.304
303
- 97 -
predicting the future, because ex ante we can just observe one of several possible
histories.307
Generally, it is simply impossible to make wise decisions neither for the purpose of
investing nor speculation without a notion of the determinants of asset-prices.308
Apart from intelligent speculation there are a lot of doubtful speculative behaviours as
speculating under the assumption to invest, speculating without knowledge and
speculating with more risk than one can bear.309 Everybody who buys stocks with
borrowed money should be aware that this behaviour is highly speculative in
nature.310
It is fair to assume that the usage of very advanced models to assess quantitatively
whether foreign currency loans with or without repayment vehicles are superior to
conventional domestic currency loans are not widely used by private households and
their advisors. Speaking frankly, if this is true then lots of them really implemented
only a very nave of speculation and are therefore exposed on chance only.
Looking back in history, some clever financial service companies promise every few
years to have an innovative model which generates returns on an investment product
above interest expenses on loans, which therefore would be the perpetuum mobile in
the world of finance.311 However, during all historic periods of euphoric speculative
behaviour, people have been impressed by something supposedly new.312
Difficult to answer is the question what can be done in the future to protect private
households from nave forms of speculations especially when these might threat their
wealth substantially. Whether prohibiting banks to lend in foreign currency is the best
alternative is an open question. Generally speaking, it is impossible to protect
individuals in a free society from wrong decisions without constraining them in their
liberty.313 The only reasonable way how to react to a speculative tendency might be
to better understand the process of the behaviour itself, because regulations
307
- 98 -
Coming back to the words of Benjamin Graham at the beginning of this thesis, an
intelligent financial analyst does not need to be a wizard in predicting market
movements, but can do a useful job by following simple principles of sound investing,
implementing a proper diversification and avoiding speculative operations which are
not suited for the client.315
314
315
- 99 -
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