BNP Paribas has launched two new indices, GALAXY Alpha and GALAXY Alpha Plus, designed to offer investors an alternative to traditional carry trade strategies.
The carry trade – which exploits the interest rate differential between currencies - has historically been a very popular strategy for investors. Over the past year, however, unprecedented volatility in foreign exchange and interest rate markets has led to two periods of marked carry unwind, during which traditional carry trade indices have underperformed.
This has driven BNP Paribas to develop a new range of indices with a unique mechanism. The GALAXY Alpha Indices seek to extract the outperformance between a dynamic basket, which is selected every month based on the currencies with the highest interest rate differentials, and a fixed benchmark basket of traditional carry pairs. This makes it possible for the indices to perform well even during periods of carry unwind.
The algorithm selects carry pairs with the widest interest rate differentials and uses a mechanism to identify and eliminate the currencies that have exhibited behaviour that is normally indicative of carry unwinds over the past month. The benchmark carry basket is then subtracted from the remaining currency pairs.
“What makes our Alpha Indices unique is the inclusion of a benchmark carry index,” explains Kara Lemont, European Head of Interest Rate and Foreign Exchange structuring. “Whereas traditional carry trade indices optimise the selection of currencies pairs, and some others can go long or short individual currencies within a basket, the Alpha Indices are the first to be specifically designed to extract the outperformance of the selected pairs versus a traditional carry basket. This gives investors more flexibility than ever before.”
The Alpha Index is market neutral carry index: it scales the static basket in order to have the same allocation in the dynamic basket and the benchmark. The Alpha Plus Index can be long, neutral or short the carry trade depending on the strength of carry or carry unwinds prevalent in the market.
Indeed, in the periods when carry trades are generally performing, this Index would provide an extra return on top of the outperformance. In the periods when the carry unwind is anticipated, the Index would provide a return by being "short" the typical carry currency pairs. It therefore constitutes at the same time an enhancement and a protection to existing carry trades, or simply an alternative for more cautious investors.