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Affirmation

I, Andreas Meixner

born on 4 November 1983, in Zwettl

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

3. that I, if the work concerns my business, obtained agreement from my


employer regarding title, form and content of my Masters Thesis.

Kirchberg am Walde, 11 April 2012

Foreign Currency Borrowing in Austrian Private Households


An Empirical Analysis

Masters Thesis for obtaining the academic degree

Master of Business Administration (MBA)


of Danube University Krems
Department for Management and Economics Danube Business School

Submitted by

Andreas Meixner

1. Advisor:
Univ.Prof. DDr. Jrgen Huber

2. Advisor:
Helga Wannerer, MA

Kirchberg am Walde, 11 April 2012

It is my basic thesis for the future as for the past that


an intelligent and well-trained Financial Analyst can do a
useful job as portfolio adviser for many different kinds of
people, and thus amply justify his existence. Also I claim
he can do this by adhering to relatively simple principles
of sound investment; e.g., a proper balance between
bonds and stocks; proper diversification; selection of a
representative list; discouragement of speculative
operations not suited for the client's financial position or
temperament and for this he does not need to be a
wizard in picking winners from the stock list or in
foretelling market movements.1
Benjamin Graham

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

Fremdwhrungskrediten bei sterreichischen Privathaushalten. Ein groer Teil von


ihnen nutzte Schweizer Franken oder Japanische Yen Kredite, welche hauptschlich
als endfllige Tilgungstrgerkredite konstruiert sind, als Ersatz fr konventionelle
Kredite in Inlandswhrung. Wenn jedoch die Theorie der ungedeckten Zinsparitt
hlt, wird erwartet, dass Zinssatzdifferentiale durch Wechselkursvernderungen
aufgewogen werden. Die Rentabilitt wurde anlehnend an die akademische Literatur
ber Whrungs-Carry-Trading anhand quartalsweiser Ertrge zwischen 1990 und
2011 gemessen. Renditen auf endfllige Kredite wurden mittels dem MSCI World
Index als Referenzprodukt fr Tilgungstrger kalkuliert. Generelle Ergebnisse sind
Durchschnittsrenditen von fast null, unattraktive Sharpe Ratios und miserable
Minimum Renditen von Fremdwhrungskrediten. Des Weiteren haben Kosten und
Steuern in Bezug stehend zu Tilgungstrgerkrediten zu einem substantiellen
Vermgensverlust gefhrt.

- 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.

Therefore, I would like to express my deepest gratitude to my supervisor Jrgen


Huber. His interest in the outcomes of this topic, useful comments on the
manuscripts and insightful discussions encouraged me to go some extra-miles in
research and analysis.

I am also thankful to the professors of my postgraduate program who made me


aware of common beliefs and taught me thinking in various perspectives. Especially
the opportunity to study at the University of British Columbia Sauder School of
Business offered a great intellectual experience.

Furthermore, I am grateful to Helga Wannerer for supervising the formal compliance


and her support in questions regarding this part of the thesis. Thanks go as well to
the administrative team of the Department for Management and Economics at the
Danube Business School, especially to Willibald Gfhler and Nina Staffenberger for
their organizational assistance throughout my studies.

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

Foreign Currency Loans in Austrian Private Households .................................... 4


2.1

Historic Development of Borrowing in Foreign Currency ............................... 4

2.2

Preferred Foreign Currencies in Austrian Household Borrowing ................... 5

2.3

Repayment Structure of Private Household Borrowing ................................. 5

2.4

Comparison within the European Monetary Union ........................................ 7

2.5

Typical Foreign Currency Borrowers ............................................................. 8

2.6

The Role of Banks and Independent Financial Advisors ............................... 9

2.7

Reasons for Foreign Currency Borrowing ..................................................... 9

2.7.1

Lower Interest Rate Levels ..................................................................... 9

2.7.2

Lower Credit Spread ............................................................................. 10

2.7.3

Herding Behaviour ................................................................................ 12

2.8
3

Features of Austrian Private Household Foreign Currency Loans ............... 13

Foreign Exchange Market ................................................................................. 15


3.1

Exchange Rate Systems ............................................................................. 15

3.2

Historic Exchange Rates and Interest Rates ............................................... 15

3.2.1

Austrian Schilling and Euro ................................................................... 15

3.2.2

Swiss Franc .......................................................................................... 16


- IV

3.2.3
3.3

Covered Interest Rate Parity ....................................................................... 20

3.4

Uncovered Interest Rate Parity ................................................................... 21

3.4.1

Theoretical Framework of Uncovered Interest Rate Parity ................... 21

3.4.2

Empirical Evidence on the Theory ........................................................ 23

3.5

Currency Carry Trading ............................................................................... 25

3.5.1

The Carry Trade Strategy ..................................................................... 25

3.5.2

Carry Trade Index ................................................................................. 26

3.5.3

Carry Trade Returns ............................................................................. 28

3.5.4

Carry Trade and Risk ............................................................................ 31

3.5.5

Peso Problems and Statistical Artefacts ............................................... 32

3.5.6

Market Frictions and Transaction Costs ................................................ 33

Carry Trading Currency Substitution in Borrowing ......................................... 34


4.1

Introduction into Private Household Borrowing ............................................ 34

4.2

Domestic versus Foreign Currency Borrowing ............................................ 35

4.3

Transaction Costs on Foreign Currency Borrowing ..................................... 39

4.4

Exchange Rate Risk on Foreign Currency Borrowing ................................. 42

4.5

Empirical Results on CHF and JPY Carry Trading ...................................... 45

4.5.1

Calculation Approach ............................................................................ 45

4.5.2

Quarterly Returns.................................................................................. 48

4.5.3

Cumulative Returns including Transaction Costs.................................. 53

4.5.4

Annualized Returns............................................................................... 55

4.6

Japanese Yen ....................................................................................... 18

Profitability on CHF and JPY Borrowings in Austria .................................... 57

4.6.1

Calculation Approach ............................................................................ 57

4.6.2

Profitability of Foreign Currency Borrowing ........................................... 58

4.6.3

Private Household Exposure on CHF and JPY Borrowings .................. 62

Carry Trading Extended The Repayment Vehicle .......................................... 66


5.1

Introduction into Private Household Borrowing - Extended ......................... 66


-V

5.2

Return Sources on a Balloon Loan including a Repayment Vehicle ............ 69

5.3

Risks on Balloon Loans including Repayment Vehicles .............................. 71

5.4

Costs of Balloon Loans................................................................................ 73

5.4.1

Credit Spread ........................................................................................ 73

5.4.2

Impact of Transaction Costs on Balloon Loans ..................................... 73

5.4.3

Fees and Taxes on the Repayment Vehicle ......................................... 74

5.5

5.5.1

Money Market ....................................................................................... 76

5.5.2

Bond Market.......................................................................................... 77

5.5.3

Equity Market ........................................................................................ 79

5.6

Major Asset Classes .................................................................................... 76

Empirical Stock Market Excess Returns ...................................................... 80

5.6.1

Calculation Approach ............................................................................ 80

5.6.2

Empirical Results .................................................................................. 81

5.6.3

Empirical Results net of Costs .............................................................. 84

Principal-Agent Relationships ............................................................................ 87


6.1

Principal-Agent Relationship in Private Household Borrowing .................... 87

6.2

Client Independent Financial Advisor Relationship .................................. 89

6.3

Client Bank Advisor Relationship.............................................................. 90

Concluding Remarks ......................................................................................... 92


7.1

Conclusion on the Empirical Findings.......................................................... 92

7.2

Fields for Future Research .......................................................................... 96

7.3

Final Remarks and Lessons Learned .......................................................... 97

Bibliography ............................................................................................................ 100

- 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

Figure 18: Standard deviations of interest rates (3 month EURIBOR and


LIBOR) and exchange rate changes (01.01.1990 11.11.2011) .............................. 43
Figure 19: Long/Short diagram of foreign currency borrowing ................................... 44
Figure 20: Quarterly returns and summary statistics on Strategy 1 (Jan.
1990 Oct. 2011) ...................................................................................................... 48
Figure 21: Quarterly returns and summary statistics on Strategy 2 (Feb.
1990 Nov. 2011) and Strategy 3 (Mar. 1990 Dec. 2011) ..................................... 49
Figure 22: Quarterly excess returns CHF and JPY (Strategy 1: Jan. 1990
Oct. 2011) .................................................................................................................. 50
Figure 23: Excess return index CHF and JPY (Strategy 1: Jan. 1990 Oct.
2011) ......................................................................................................................... 51
Figure 24: Excess return index CHF (Strategy 1, Strategy 2 and Strategy
3) ............................................................................................................................... 52
Figure 25: Excess return index JPY (Strategy 1, Strategy 2 and Strategy 3) ............ 52
Figure 26: Excess return index 50/50 portfolio (Strategy 1, Strategy 2 and
Strategy 3) ................................................................................................................. 53
Figure 27: Excess return index CHF net of transaction costs (Strategy 1,
Strategy 2 and Strategy 3) ......................................................................................... 54
Figure 28: Excess return index JPY net of transaction costs (Strategy 1,
Strategy 2 and Strategy 3) ......................................................................................... 54
Figure 29: Excess return index 50/50 portfolio net of transaction costs
(Strategy 1, Strategy 2 and Strategy 3) ..................................................................... 55
Figure 30: Annualized return statistics of Strategy 1, Strategy 2 and
Strategy 3 .................................................................................................................. 56
Figure 31: Annualized return statistics net of transaction costs of Strategy
1, Strategy 2 and Strategy 3 ...................................................................................... 56
Figure 32: Total CHF and JPY borrowings of Austrian non-monetary
financial institutions (Q4 1998 Q4 2011) ................................................................. 57
Figure 33: Absolute exchange rate changes and interest differential gains
on CHF borrowings of Austrian non-monetary financial institutions (Q1
1999 Q4 2011)........................................................................................................ 59
Figure 34: Cumulative exchange rate changes and interest rate differential
profits on CHF borrowings of Austrian non-monetary financial institutions
(Q1 1999 Q4 2011)................................................................................................. 59

- 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

Figure 50: Intermediation spread between 10 year government bond yield


and 3 month interbank rate ........................................................................................ 79
Figure 51: Quarterly MSCI World gross excess return statistics of Strategy
1, Strategy 2 and Strategy 3 (funded via 3 month CHF respectively JPY
LIBOR)....................................................................................................................... 82
Figure 52: Annualized return statistics of Strategy 1, Strategy 2 and
Strategy 3 .................................................................................................................. 82
Figure 53: Excess return index on a CHF funded investment into MSCI
World Gross Index (Strategy 1, Strategy 2 and Strategy 3) ....................................... 83
Figure 54: Excess return index on a JPY funded investment into MSCI
World Gross Index (Strategy 1, Strategy 2 and Strategy 3) ....................................... 83
Figure 55: Quarterly MSCI World net excess return statistics of Strategy 1,
Strategy 2 and Strategy 3 net of costs (funded via 3 month CHF
respectively JPY LIBOR) ........................................................................................... 84
Figure 56: Annualized return statistics net of transaction costs of Strategy
1, Strategy 2 and Strategy 3 ...................................................................................... 85
Figure 57: Excess return index on a CHF funded investment into MSCI
World net of taxes, credit spreads and transaction costs (Strategy 1,
Strategy 2 and Strategy 3) ......................................................................................... 85
Figure 58: Excess return index on a JPY funded investment into MSCI
World net of taxes, credit spreads and transaction costs (Strategy 1,
Strategy 2 and Strategy 3) ......................................................................................... 86

-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

Federal Ministry of Social Affairs


and Consumer Protection

bn

billion

CAD

Canadian dollar

CAPM

Capital Asset Pricing Model

CFA

Chartered Financial Analyst

CHF

Swiss franc

CME

Chicago Mercantile Exchange

DEM

German mark

EEIG

European Economic Interest


Grouping

ETF

Exchange Traded Fund

EU

European Union

EUR

Euro

EURIBOR

Euro Interbank Offered Rate

FCU

Foreign currency unit

FMA

Austrian Financial Market


Authority

FRF

French franc

GBP

British pound

JPY

Japanese yen

LIBOR

London Interbank Offered Rate

LTCM

Long Term Capital Management

MSCI

Morgan Stanley Capital


International

- XII

NBER

National Bureau of Economic


Research

NOK

Norwegian krone

NZD

New Zealand dollar

OECD

Organisation for Economic Cooperation and Development

OeNB

Austrian National Bank

S&P 500

Standard & Poor's 500

SEK

Swedish krona

SR

Sharpe ratio

TED

Treasury bill Eurodollar


Difference

USD

United States dollar

VIBOR

Vienna Interbank Offered Rate

WKO

Austrian Economic Chambers

- 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.

Historically the portion of foreign currency denomination on total loans in Austrian


private households has been negligible until in the mid of the 1990s substantial grow
started, reaching a peak of around one third of private household debt around 2006.
Swiss franc (CHF) and Japanese yen (JPY) loans account together for almost 100%
of foreign currency denominated debt. Furthermore, Austrian private households hold
a substantial share of total foreign currency borrowing within the European Monetary
Union. Even though an ultimate explanation of this exceptional behaviour of Austrian
private households is still missing, herding and the activity of financial advisors have
been strong contributors. Different to euro (EUR) denominated borrowing, foreign
currency loans are constructed predominantly as balloon loans including a
repayment vehicle for covering the loan amount at maturity.

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.

cf. FMA 2010: pp. 4 7, translation by the author

- 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).

The impact of transaction costs on foreign currency loans is assessed by the


increase of the internal rate of return on an artificial created loan using terms on
published bank offers. Foreign currency related fees raise the internal rate of return
on the loan by 0.22% (respectively 0.16% for a balloon loan).

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.

Since a huge majority of foreign currency debt in private households is constructed


as balloon loans using repayment vehicles (investment products) to cover the
outstanding debt amount at maturity, the relevant payoff to private households is the
excess return between the investment yield and borrowing costs. However,
repayment vehicles in the money market or riskless bonds struggle to cover all
related costs (transaction fees, credit spread, taxes, etc.). Equivalent to the excess
return of foreign currency versus domestic currency denominated loans, the paper
reports the excess return of the equity market (represented by the MSCI World index)

- 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.

A conflict of interest due to the compensation scheme of financial advisors might


have been a pitfall to foreign currency borrowers. To maximize commissions,
financial advisors are prone to prefer foreign currency denominated balloon loan
constructions with a repayment vehicle in their recommendation.

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.

In 2003 Austrian Financial Market Authority (FMA) published minimum requirements


to banks for their foreign currency denominated lending business. According to them,
lending institutions have been forced to analyse the private household repayment
ability of EUR denominated loans as well3 and now have to make conservative return
estimates of the repayment vehicles.4 However, the recent financial crisis stressed
the riskiness of these borrowing products to private households, lenders and has
3
4

FMA 2003a: n.p., translation by the author


FMA 2003b: n.p., translation by the author

-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.

FMA 2010: p. 4, translation by the author


FMA 2010: p. 5, translation by the author
7
FMA 2010: p. 4, translation by the author
8
FMA 2010: p. 7, translation by the author
6

-2-

However, the center of interest is the profitability of foreign currency borrowing in


contrast to domestic denominated one. To answer this question, Chapter 4 exhibits
excess return statistics of foreign currency versus equivalent domestic currency
denominated borrowing on basis of quarterly roll-over periods (including and
excluding the impact of transaction costs from 1990 to 2011). In addition the chapter
reports an approximation of the absolute payoffs to Austrian borrowers.

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-

2 Foreign Currency Loans in Austrian Private Households


2.1 Historic Development of Borrowing in Foreign Currency
Foreign currency borrowing to Austrian private households has played a negligible
role of the total household borrowing for a long time until it became a very crucial
factor. In 1987 the share of foreign currency loans was just 0.2% of the total private
household borrowings and it reached the peak in 2006 with roughly 32% (see Figure
1). In the middle of the 1990s the borrowing in foreign currency in Austrian
households started to increase. Especially the years from 1997 to 2000 have
contributed with enormous growth rates to make foreign currency loans an important
issue in the field of private household borrowing.

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

OeNB, authors calculations


cf. Boss 2003: p. 10, translation by the author
11
cf. Waschizek 2002: p. 91, translation by the author
10

-4-

2.2 Preferred Foreign Currencies in Austrian Household Borrowing


Generally the Austrian household foreign currency borrowing is dominated by two
currencies namely the Swiss franc and the Japanese yen. In 2002 the distribution
between these two where nearly fifty-fifty, meaning that one half of the foreign
currency borrowing was taken in Swiss franc (CHF) and the second half in Japanese
yen (JPY) while other currencies have played a negligible role during the whole
period from 2002 until 2011 (see Figure 2). The large shift from the Japanese yen to
the Swiss franc finds its reasons in an increase of the interest rate differential
between euro and franc while at the same time the interest rate differential between
euro and yen was narrowing and furthermore the yen depreciated versus the euro.12

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)

2.3 Repayment Structure of Private Household Borrowing


The repayment structure of private Austrian household loans in foreign currency is
very different to typical borrowings in euro. While in euro 85% of the loans are repaid
continuously during the lifetime (either constant capital repayments or annuities) this
form of repayment is chosen in just 19% of Swiss franc denominated loans and in
13% in Japanese yen loans. In other words 15% of euro, 81% of Swiss franc and
87% of yen borrowings in Austrian households are structured to be repaid at the end
of the lifetime so-called balloon loans (see Figure 3).

12
13

cf. Boss 2003: p. 9, translation by the author


OeNB, authors calculations

-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

Balloon Loan incl. Repayment Vehicle

Figure 3: Repayment structure of Austrian private household debt (Q2 2011)

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

OeNB, authors calculations


OeNB, authors calculations

-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.

3-6M. 6M.-1Y. 1-2Y.

2-3Y.

EUR

3-4Y.

CHF

4-5Y.

5-7Y.

7-10Y. 10-15Y. 15-20Y. >20Y.

JPY

Figure 5: Residual time to maturity of balloon loans with repayment vehicle (Q2 2011)

16

2.4 Comparison within the European Monetary Union


Austria has a very special role of foreign currency loans within the European
Monetary Union. The actual Austrian share of private household borrowing within the
Euro-Area is 2.7% while in foreign currency borrowing the picture is dramatically
different. Here the Austrian private households are the borrower of 40% of all
outstanding foreign currency debt in the Euro-Area (see Figure 6).

16

OeNB, authors calculations

-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

2.5 Typical Foreign Currency Borrowers


A study based on a survey in Austrian households found that foreign currency
borrowers are financial more literate and less risk averse than euro borrowers.19
Furthermore they are a bit better educated, receive a higher income (543 euro more
17

OeNB, ECB, authors calculations


OeNB, ECB, authors calculations
19
cf. Beer et al 2008: p. 116
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

2.6 The Role of Banks and Independent Financial Advisors


Banks often claim that the business in foreign currency loans is very demand driven,
especially by loan brokers and because of the competition banks are forced to offer
them.22 But this claim could also be interpreted as self-serving to reduce the
reputational and legal risks they face.23 Survey data also shows that a large portion
of foreign exchange borrowers (above 30%) received their first information about
foreign currency loans from a bank24 which is supported by findings (a mystery
shopping among Austrian largest banks) that bank advisors also actively offer this
foreign currency loans as borrowing alternative.25

An important role in the development of foreign currency borrowings in Austria played


independent financial advisors and financial advisory firms.26 A mystery shopping
found, that especially the favoured offering of foreign currency loans in combination
with repayment vehicles seems to be different to offers by banks.27 This survey also
shows that especially financial advisors failed to calculate a loan in euro in order to
prove the risk bearing ability of the potential borrower. 28

2.7 Reasons for Foreign Currency Borrowing


2.7.1 Lower Interest Rate Levels
The most important argument for preferring the borrowing in foreign instead in
domestic currency is the cost advantage based on the lower interest rate level
abroad. A survey result among financial advisory firms and independent financial
advisors shows that in the consulting process the lower interest rate level and

20

cf. Beer et al 2008: pp. 116 117


cf. Beer et al 2008: p. 110
22
cf. Nordberg 2003: p. 128, translation by the author
23
cf. Beer et al 2008: p. 110
24
cf. Market 2003: p. 2, translation by the author
25
cf. Prantner 2003: p. 2, translation by the author
26
cf. Boss 2003: p. 16, translation by the author
27
cf. Market 2007: p. 6, translation by the author
28
cf. Market 2007: p. 2, translation by the author
21

-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.

2.7.2 Lower Credit Spread


An often raised argument is that the credit spread (henceforth, it refers to the
absolute credit spread because the difference to multiplicative credit spreads is
indistinguishable at low interest rate levels)31 in foreign currency borrowing is lower
than in domestic currency borrowing. Such an argument would be puzzling because
based on the higher riskiness of foreign compared to domestic currency loans banks
should clearly charge a higher credit spread not a lower one in the foreign currency
lending business.

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

cf. Cocca 2010: p. 24, translation by the author


cf. Market 2003: p. 3, translation by the author
31
cf. Bekaert/Hodrick 2009: p. 390
32
cf. Fembek et al 2005a: p. 66, translation by the author
30

- 10 -

Also a comparison to Germany and France (both have a border to Switzerland)


shows that the absolute interest rates for housing loans to private households
developed very similar during the time of the highest growing rates of foreign
currency borrowings in Austria (see Figure 8). Even when the data is not harmonized
it is visible that interest rates in Germany are most of the time just a bit lower and in
France markedly higher than in Austria and rates converged over time. At least
private households in France would be more exposed to substitute the currency in
the borrowing business as the interest rate level has been higher during the whole
period but they did not show the same behaviour as Austrian households.

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

Eurostat, authors calculations


cf. Cocca 2010: p. 25, translation by the author

- 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.

Nevertheless an explanation just based on the cost advantage of a lower credit


spread is also weak due to the finding that instead of continuous repaying most of the
foreign currency loans are balloon loans.35 And if private households would use it
widely as credit spread arbitrage the currency exposure would be either fully
eliminated (via hedging) and the outstanding debt would be repaid similar as it is
done with euro-loans or the switching approach would be widely used. Also the
price pressure alone cannot explain it fully, because when it is possible to lower
spreads with negotiation it should be possible in all currencies and for the mortgage
broker it should not play a role for which funding currency the advisory takes place
(except for incentive conflicts which are described closer in chapter 6).

2.7.3 Herding Behaviour


Herding is also a possible explanation of the special borrowing behaviour of Austrian
private households compared to private households in other countries of the
European Monetary Union.36 Especially the increase of the reporting in public media
about foreign currency loans in the second half of the 1990s supported the herding
behaviour in Austria while the media reporting in other countries did not show such a
picture.37

A dynamic model based study supports the herd behaviour explanation to a


significant extent for the difference in foreign exchange borrowing to other countries

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

2.8 Features of Austrian Private Household Foreign Currency Loans


As previously shown the Swiss franc dominates as funding currency with a large
distance to the Japanese yen.40 For redeeming the loan most borrowers use socalled repayment vehicles quite different to euro borrowings.41 Most commonly the
lifetime of such loans is between 15 and 25 years 42 and the main usage of this
borrowing method is housing.43
The charged interest rate is based on the LIBOR (usually 3 or 6 month LIBOR)44 plus
the individual credit spread based on the credit rating of the customer. The spread is
between 0.5% and 2% (most common 1.5%) and includes usually the right to the
customer to switch in euro or another currency at each roll-over date but also a
forced conversation right to the lending bank which could then switch the customer
into the euro without agreement of the borrower.45

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

cf. Tzanninis 2005: p. 19


cf. Waschizek 2002: p. 97, translation by the author
40
cf. p. 4
41
cf. p. 5
42
cf. Boss 2003: p. 17, translation by the author
43
cf. Boss 2003: p. 7, translation by the author
44
cf. Waschiczek 2002: p. 92, translation by the author
45
cf. Boss 2003: pp. 16 17, translation by the author
46
cf. Boss 2003: p. 17, translation by the author
47
cf. Fembek et al 2002: p. 108, translation by the author
39

- 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

cf. Fembek et al 2002: p. 108, translation by the author


cf. Fembek et al 2002: pp. 114 115, translation by the author
50
cf. Kollmann/Prantner 2006: p. 2, translation by the author
51
cf. Kollmann/Prantner 2006: p. 2, translation by the author
52
cf. Boss 2003: p. 18, translation by the author
49

- 14 -

3 Foreign Exchange Market


3.1 Exchange Rate Systems
The most important currencies related to Austrian private household debt namely the
euro (EUR) the Swiss franc (CHF) and the Japanese yen (JPY) are floating
exchange rates, meaning that they are freely traded and show continuous
fluctuations.53 But due to central bank interventions executed through buying and
selling their own currency a pure floating rate system does not exist in reality and
therefore each of the named currencies are traded in a dirty float currency system.54
During the turmoil of the European debt crisis which caused the EUR to weaken,
Switzerland got difficulties in their export industry, inducing Swiss Central Bank to
decide on the 6th September 2011 to implement a floor of the exchange rate to the
EUR (at the level of 1.20 CHF per EUR) by buying foreign currencies without any
limitation in size to help the weakening Swiss economy and reduce the deflation
risk.55

3.2 Historic Exchange Rates and Interest Rates


3.2.1 Austrian Schilling and Euro
The history of Austrias currencies in the recent past (1980s until now) is strongly
dominated by the monetary policy of Germany. As of 1982 Austria successfully
pegged the exchange rate of the Austrian schilling (ATS) to the German mark (DEM)
after some years of close orientation on the foreign exchange rate to the DEM.56 A
speculative attack in 1993 on the central rate of the ATS versus the DEM central rate
remained unsuccessful.57 During the later 1980s Austria stepwise abolished capital
flow restrictions and reached full liberalization on November 4th 1991.58

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

cf. International Monetary Fund 2011: Appendix Table II-9


cf. Bekaert/Hodrick 2009: p. 137
55
cf. Swiss National Bank 2011: p. 7
56
cf. Klausinger 2007: p. 78, translation by the author
57
cf. Mooslechner et al 2007: p. 27
58
cf. Mooslechner et al 2007: pp. 34 36
59
cf. Howells/Bain 2008: p. 488
60
cf. Howells/Bain 2008: p. 488
54

- 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

In this paper whenever it is referred to EUR as exchange rate prior 1999 it is


basically the ATS converted by 13.7603. Also interest rates prior these date are
former comparable Austrian rates. The reason is that the aim of the paper is to
examine the standpoint of private Austrian households. Empirical studies use
therefore mostly the DEM as reference for pre-euro foreign exchange rates but due
to the described close relationship between the DEM an the ATS results are
comparable (at least to some extent) to Austrian conditions.

3.2.2 Swiss Franc


The currency in which Austrian private households face by far the largest exposure in
their foreign exchange borrowing is the Swiss franc (CHF).63 From 1990 until now the
EUR (respectively the ATS prior 1999) depreciated versus the CHF in total by 31%
which is on average 1.7% per year from 1.8 to slightly above 1.2 CHF per EUR (see
Figure 9). The largest drop occurred during the recent financial crisis, and here
especially within the European sovereign debt crisis where Switzerland benefited
from its safe haven status.

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

cf. Bekaert/Hodrick 2009: p. 168


cf. Howells/Bain 2008: p. 491
63
cf. p. 4
62

- 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

OANDA, authors calculations


cf. Dimson et al 2011: p. 48
66
cf. Dimson et al 2011: p. 48
67
cf. Keating et al 2010: p. 34
65

- 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)

3.2.3 Japanese Yen


From 1990 until 2011 the EUR depreciated versus the JPY by 37% respectively 2.1%
per year which is similar to the EUR/CHF currency pair but compared to them the
EUR/JPY exchange rate faced extended periods of ups and downs (see Figure 11).

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 the EUR/JPY is also characterized by more extended


periods of upward movements, especially during the years from 2001 until 2008 the
EUR almost doubled the value versus the JPY. But on the other hand it is also visible
that downward corrections are mostly very sharp as we see from 1999 until 1993,
from 1998 until 2000 and in 2008. Especially during the years of 1998 until the end of
2000 the EUR depreciated very strong versus the 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

OeNB, Reuters, authors calculations

- 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

OANDA, authors calculations


cf. Dimson et al 2011: p. 41

- 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)

3.3 Covered Interest Rate Parity


The following part describes the theoretical relationship how domestic and foreign
interest rates and the correspondent currency exchange rates are linked together
including the literature on empirical investigations and potential explanations.

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

OeNB, Reuters, authors calculations


cf. Bekaert/Hodrick 2009: p. 173

- 20 -

Equation 1: Covered interest rate parity

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

Equation 2: Forward exchange rate

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

3.4 Uncovered Interest Rate Parity


3.4.1 Theoretical Framework of Uncovered Interest Rate Parity
Uncovered interest rate parity is the condition where the investment in the foreign
money market has due to the uncertain exchange rate the same expected return (on
domestic currency basis) as a domestic money market investment.77 The difference
to covered interest rate parity is that the exchange rate exposure is not hedged and
so the return is dependent on the future spot rate. Equation 3 shows this relationship,
where again iL denotes for the interest rate of the investment currency, iS for the
interest rate of the funding currency, St the current spot rate and Et(St+1) the expected
spot rate in the future (both exchange rates stand for units of the funding currency
per one unit of the investing currency).
73

cf. Bekaert/Hodrick 2009: p. 187


cf. Bekaert/Hodrick 2009: p. 187
75
cf. Bekaert/Hodrick 2009: p. 187
76
cf. Bekaert/Hodrick 2009: pp. 187 192
77
cf. Bekaert/Hodrick 2009: p. 211
74

- 21 -

Equation 3: Uncovered interest rate parity

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

Equation 4: Unbiasedness hypothesis

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

cf. Bekaert/Hodrick 2009: p. 211


cf. Bekaert/Hodrick 2009: p. 212
80
cf. Bekaert/Hodrick 2009: p. 221
81
cf. Bekaert/Hodrick 2009: p. 224
79

- 22 -

of the equation is most common expressed by the difference of the natural logarithms
of St+1 and St.82

Equation 5: Regression analysis on the unbiasedness hypothesis

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

3.4.2 Empirical Evidence on the Theory


Lots of academic studies investigated the validity of the uncovered interest rate parity
and the unbiasedness hypothesis and just a small overview can be provided in the
following.

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

cf. Flood/Rose 2001: p. 4


cf. Flood/Rose 2001: p. 4
84
cf. Bekaert/Hodrick 2009: p. 222
85
cf. Bansal/Dahlquist 2000: p. 116
86
cf. Lothian/Wu 2011: pp. 450 451
83

- 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

Running a regression analysis on the same dataset delivers a slope coefficient ()


significantly different from one for all currency pairs (which suggests a forward rate
biased) but with a low explanatory power (R) for all regressions.94

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

cf. Lothian/Wu 2011: pp. 454 455


cf. Lothian/Wu 2011: p. 454
89
cf. Lothian/Wu 2011: p. 454
90
cf. Lothian/Wu 2011: p. 463
91
cf. Lothian/Wu 2011: p. 457
92
cf. Bekaert/Hodrick 2009: p. 223
93
cf. Bekaert/Hodrick 2009: p. 224
94
cf. Bekaert/Hodrick 2009: p. 224
95
cf. Bansal/Dahlquist 2000: p. 118
96
cf. Bansal/Dahlquist 2000: p. 127
88

- 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

Regression results of 23 countries with data of the 1990s provide a strong


heterogeneity of slope estimates (i.e. coefficients vary strongly across countries).100
Also the comparison of members and non-members of the OECD does not give
significantly different results.101 Concluding remarks are that the theory of uncovered
interest rate parity worked better in the 1990s in contrast to the previous negative
slope estimates in the past but far from perfect.102
Rolling five year regressions with monthly data on the DEM/USD pair (from 1973
1995) exhibit a considerable variation of the slope coefficient () over different
sample periods.103 This analysis also shows that is significantly negative between
June 1985 and May 1990.104

If the unbiasedness hypothesis is not valid and someone can successfully derive the
bias quantitatively it might open profit opportunities.

3.5 Currency Carry Trading


3.5.1 The Carry Trade Strategy
Whereas different regression analysis can try to exploit the forward bias in a
sophisticated way, currency carry trading is one of the simplest currency speculation
strategies. It is basically borrowing in currencies with low interest rates and investing
97

cf. Bansal/Dahlquist 2000: p. 128


cf. Bansal/Dahlquist 2000: p. 129
99
cf. Bansal/Dahlquist 2000: p. 140
100
cf. Flood/Rose 2001: p. 11
101
cf. Flood/Rose 2001: p. 14
102
cf. Flood/Rose 2001: p. 14
103
cf. Baille/Bollerslev 2000: p. 477
104
cf. Baille/Bollerslev 2000: p. 477
98

- 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).

Equation 6: Expected currency carry trade return (money market)

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).

Equation 7: Expected currency carry trade return (forward market)

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.

3.5.2 Carry Trade Index


The Deutsche Bank G10 Currency Harvest EUR Index (Bloomberg: DBHVG10E)
gives an indication of carry trading in the real world. The Index has a defined pool of
currencies (AUD, CAD, CHF, EUR, GPB, JPY, NOK, NZD, SEK and USD) and
105

cf. Bekaert/Hodrick 2009: p. 227

- 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

cf. Deutsche Bank 2007: n.p.


cf. Deutsche Bank 2007: n.p.
108
cf. Deutsche Bank 2007: n.p.
109
cf. Deutsche Bank: [Internet] https://index.db.com/dbiqweb2/home.do?redirect=productPage&index
id=57025&assetClass=FX&page=do%2FFXAnalytic%3Fcmd%3DFxYield%26investorRuleBasedDyna
micIndices%3D57025%26singleCurrencyTrades%3Dnone%26indexName%3DG10CurrencyHarvestE
UR%26indexId%3D57025%26date%3D12122011 12 December 2011
110
Deutsche Bank, authors calculations
107

- 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

However, it is important to repeat that real world investments on a replication of the


index have to cover transaction costs as well as management fees and therefore a
look on the index would lead to an overestimation of returns, nevertheless the
performance is still impressive.

3.5.3 Carry Trade Returns


If the theory of uncovered interest rate parity holds in real world domestic and foreign
money market investments with the same riskiness should deliver on average similar
results, hence there should be no excess return provided by comparing one strategy
to the other. However, as seen for the unbiasedness hypothesis empirical studies
provide strong evidence that there is excess return at least under some
circumstances.

The comparison of holding period returns of (long-term and short-term) domestic


versus foreign bonds over two centuries (1800 until 1999) for FRF/GBP and
USD/GBP shows that the unconditional mean returns over the whole sample period
are insignificant different for the FRF/GBP pair (for both long-term and short-term
bonds) and for the USD/GBP pair at long-term bond investments.115 Even though
short-term bonds in USD delivered significantly higher returns compared to GBP it

111

cf. Invesco PowerShares 2011: p. 6


cf. Invesco PowerShares 2011: p. 6
113
cf. Bekaert/Hodrick 2009: p. 230
114
cf. Bekaert/Hodrick 2009: p. 230
115
cf. Lothian/Wu 2011: p. 459
112

- 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

cf. Lothian/Wu 2011: p. 459


cf. Burnside et al 2011a: pp. 865 866
118
cf. Burnside et al 2011a: p. 866
119
cf. Burnside et al 2011a: p. 866
120
cf. Burnside et al 2011b: pp. 514 515
121
cf. Burnside et al 2008: p. 583
122
cf. Burnside et al 2008: p. 586
123
cf. Burnside et al 2011a: pp. 873 875
117

- 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

cf. Burnside et al 2011a: pp. 875 876


cf. Burnside et al 2011a: p. 876
126
cf. Jurek 2009: p. 7
127
cf. Jurek 2009: p. 7
128
cf. Jurek 2009: pp. 7 8
129
cf. Jurek 2009: p. 8
130
cf. Jurek 2009: p. 8
131
cf. Jurek 2009: p. 23
132
cf. Jurek 2009: p. 24
133
cf. Jurek 2009: p. 24 25
125

- 30 -

However, as the foreign exchange market is interconnected and highly liquid,134


temporary anomalies would arbitraged away which is inconsistent with findings
showing an increase of the carry premium over time (comparison of the timeframes
1983 1995 and 1995 2008) while also the trading volume increased sharply.135

3.5.4 Carry Trade and Risk


One possible explanation for the empirical failure of uncovered interest rate parity
theory and associated high carry trade returns is that this strategy is exposed to a
special kind of risk.

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

cf. Lustig/Verdelhan 2009: p. 362


cf. Lustig/Verdelhan 2009: p. 372
136
cf. Burnside 2011c: pp. 10 11
137
cf. Lustig et al 2011: p. 3773
138
cf. Lustig/Verdelhan 2009: p. 377
139
cf. Christiansen et al 2010: p. 12
140
cf. Christiansen et al 2010: p. 13
141
cf. Christiansen et al 2010: p. 18
135

- 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

3.5.5 Peso Problems and Statistical Artefacts


In the literature a peso problem is when market participants rationally anticipate
(usually dramatic) events which have not occurred in the historic sample yet.147 This
behaviour was observed from the successful exchange rate peg of the Mexican peso
(MXP) to the USD in the years 1955 to 1975 (12 MXP per one USD).148 In the early
1970s Mexico offered with high interest rates the possibility to lend in the United
States (USD) for investing the proceeds in Mexico (MXP) gaining the carry.149 While
a real arbitrage opportunity would not exist that long the possible explanation was
that speculators anticipated a MXP devaluation (which happened 1976 with a 45%
decline).150 So instead of an arbitrage opportunity it was a speculation on the
persistence of the MXP/USD peg.151

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

cf. Brunnermeier et al 2009: p. 315


cf. Brunnermeier et al 2009: p. 315 317
144
cf. Brunnermeier et al 2009: p. 324
145
cf. Brunnermeier et al 2009: p. 337
146
cf. Jurek 2009: p. 12
147
cf. Bekaert/Hodrick 2009: p. 232
148
cf. Bekaert/Hodrick 2009: p. 232
149
cf. Jones 2008: pp. 78 - 79, translation by the author
150
cf. Jones 2008: p. 79, translation by the author
151
cf. Jones 2008: p. 79, translation by the author
152
cf. Burnside 2009: p. 355
143

- 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

3.5.6 Market Frictions and Transaction Costs


Empirically it is evident that even when transaction costs reduce the returns on the
carry trade they fail to explain the whole profitability.156

Moreover, although empirical evidence suggests profit opportunities, in real world


liquidity constraints may explain empirical results when slow capital moves bring
rates gradually in equilibrium instead of an immediate jump.157

Market frictions may also be able to explain a theoretical misinterpretation of profit


opportunities when a currency crash forces speculators to de-lever their positions
and can therefore not participate on a market rebound.158

153

cf. Burnside et al 2011a: p. 885


cf. Baille/Bollerslev 2000: p. 486
155
cf. Lothian/Wu 2011: p. 470
156
cf. Burnside et al 2011a: p. 865
157
cf. Brunnermeier et al 2009: pp. 314 315
158
cf. Brunnermeier et al 2009: p. 325
154

- 33 -

4 Carry Trading Currency Substitution in Borrowing


4.1 Introduction into Private Household Borrowing
This chapter examines how private households are implementing the currency carry
trading strategy through foreign currency borrowing for financing long term
investments (typically for housing). Therefore the following story essentially
summarizes the idea behind an innovation of Austrian private household borrowing.

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 -

opportunity. Because of the additional wealth, which is expected to be created, it


would be rational to take the foreign currency denominated loan instead of a
domestic currency one.

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.

4.2 Domestic versus Foreign Currency Borrowing


Mortgage loans are commonly paid back with an annuity, which is basically an
equally sized payment at each period (except for changes in the interest rate if the
loan has a variable rate). Equation 8 exhibits the way of calculating the annuity where
the term A denotes the annuity, i is the interest rate, C is the borrowed amount and T
is the total number of payment periods (i.e. the lifetime of the loan expressed in
months, quarters, etc.).

Equation 8: Annuity in a mortgage payment

For a comparison of two different loans one denominated in domestic currency


(henceforth EUR denotes domestic currency unit) and one denominated in foreign
currency (henceforth FCU denotes foreign currency unit), suppose the foreign
exchange rate (EUR/FCU) is 1 and expected to be constant over the whole lifetime of
25 years while the required loan amount is 150,000 EUR. Furthermore the interest
rate on the domestic currency loan is 4% per year, respectively 2.5% on the foreign
currency (both expected to be constant) and payments have to be made at the end of
each quarter. Plugging in the numbers, results in a quarterly annuity of 2,380 EUR for
the domestic currency one, respectively 2,022 EUR (because EUR/FCU is 1) for the
foreign currency loan. Hence the foreign currency loan comes with an annuity which
is 15% lower than the domestic one.

- 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 -

for independent financial advisors in the sales process.161 Therefore in reality it is


very likely that the maturity is held similar to domestic borrowing and the increase in
wealth is consumed over the whole lifetime of the debt through lower annuity
payments. Even when this might be counterintuitive since higher annuities lead to
earlier repayment and hence lower interest expenses, this behaviour is consistent
with findings that people attach greater weight to lower immediate rewards compared
to higher rewards in the future.162

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).

Equation 9: Mortgage payment (including exchange rates)

Suppose, based on the previous example, the domestic currency depreciates


continuously by 1.5% each year (respectively 0.375% each quarter). This means
while the annuity expressed in FCU remains constant at 2,022, it is (exponentially)
increasing on a EUR basis due to the depreciation of the domestic currency. Figure
15 provides the annuities of domestic and foreign currency borrowing (denominated
in EUR) using the numbers given in the example.

161
162

cf. Cocca 2010: p. 24, translation by the author


cf. Zweig 2007: pp. 276 280, translation by the author

- 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

Figure 15: Mortgage payment denominated in domestic 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.

4.3 Transaction Costs on Foreign Currency Borrowing


We now investigate the impact of transaction costs and additional fees of foreign
currency lending. Taking the numerical example, except for the exchange rate
changes whereas CEUR denotes the required EUR amount (150,000 EUR), T equals
the number of payment periods (25 years, respectively 100 quarters) and i stands for
the interest rate (2.5% per year). In addition the bank charges a bid-ask spread of 1%
(i.e. SAsk equals 1.005 while SBid equals 0.995), 15 EUR per quarter for a clearing
account (FEUR) and 0.275% transaction fees on each transfer between foreign and
domestic currency (f). Besides this, the borrower has to make an extra upfront tax
payment of 360 EUR (i.e. 1.2% tax on the difference between 120% and 140% of
150,000 EUR) for listings of the mortgage in the land register (LEUR). The reason is
that while banks list 120% of the loan amount for borrowings denominated in EUR,
they require up to 140% for foreign currency loans.166 Equation 10 provides the
fundamental of calculating the annuity in EUR including the described additional
costs.

165
166

cf. Brunnermeier et al 2009: p. 325


cf. Kollmann/Prantner 2006: p. 6, translation by the author

- 39 -

Equation 10: Mortgage payment including fees (and exchange rates)

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)

Foreign Currency (incl. 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%

Foreign currency borrowing (denominated in EUR)


incl. fees
excl. fees
EUR
EUR
ALL
bid-ask
F
f
L
2,022
2.50%

2,073
2.72%

2,042
2.59%

2,037
2.57%

2,033
2.55%

2,027
2.52%

interest rate including fees

0.22%

0.09%

0.07%

0.05%

0.02%

Figure 17: Fee-impact on mortgage interest rate

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 -

4.4 Exchange Rate Risk on Foreign Currency Borrowing


Through the uncertainty of future foreign exchange rates, borrowing in another than
domestic currency is exposed to additional risk. Equation 11 shows the typical
portfolio structure of private households (non-relevant assets are excluded) using
foreign currency borrowing.

Equation 11: Private household portfolio including foreign currency borrowing

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.

Generally speaking, private household debt is transferring future consumption into


the present, meaning that instead of saving today and investing tomorrow, debt offers
the possibility to invest today and save tomorrow. Therefore debt gets redeemed by
savings (not-consumption) of future income. But while debt in EUR can get covered
by not-consumed income in EUR, in foreign currency borrowing the size of notconsumption in the future is depended on the future exchange rate (EUR/FCU) since
the EUR income has to be converted to FCU in order to repay the loan.
Consequently borrowing in foreign currency requires a higher potential savings rate
(and therefore usually a higher income) otherwise the borrower might face troubles in
paying annuities in times when the foreign currency appreciates. In fact there is also
a variability of the annuities by borrowing in EUR because of changes in interest
rates, but to a much smaller degree than the impact of exchange rate changes have.
Therefore, Figure 18 provides an overview of the standard deviations of the 3 month
EURIBOR (VIBOR before 1999) as well as the 3 month CHF and JPY LIBOR.

- 42 -

Additionally the table exhibits the standard deviations (annualized by the square root
of 252) of EUR/CHF and EUR/JPY daily changes.

Interest rates (EURIBOR / LIBOR)


Exchange rates
EUR
CHF
JPY
EUR/CHF EUR/JPY
2.46%
2.58%
2.22%
5.41%
11.38%
Figure 18: Standard deviations of interest rates (3 month EURIBOR and LIBOR) and exchange
171
rate changes (01.01.1990 11.11.2011)

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).

Figure 19 exhibits a long-short diagram (equivalent to currency carry trading) of the


foreign currency exposure (EUR/FCU) in percent of the initial amount, which a
foreign currency borrower faces (maturity of 25 years and 2.5% interest rate).
171
172

OANDA, Reuters, OeNB, authors calculations


cf. Lustig/Verdelhan 2009: p. 378

- 43 -

100%
50%
EUR
0%
0

25

FCU

-50%
-100%

Figure 19: Long/Short diagram of foreign currency borrowing

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.

However, similar to traditional carry trading, the whole long-short exposure


disappears after unwinding the foreign currency exposure (in fact, the borrower
would end up with a short exposure denominated in EUR).

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).

4.5 Empirical Results on CHF and JPY Carry Trading


4.5.1 Calculation Approach
Several ways are possible to investigate the empirical results of borrowing
substitution. One approach is to use real-life loans obtained from lending institutions
for calculating the returns. While through this approach the most relevant questions
for private households (real-life returns, behaviour of funding currency switches, cost
impacts, etc.) can be answered, it has to grapple with some problems. One constraint
of banking data is that these loans might be biased to some degree since there is
evidence of inconsistency in lending behaviour. While banks in the western part of
Austria started very early to offer foreign currency loans, banks in the eastern part of
Austria started later.174 Also, some banks might be involved more actively in this field
than others. For this reason even real data might give a skewed picture of the reality.
174

cf. Boss 2003: pp. 9 10, translation by the author

- 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.

Therefore the following empirical investigation of whether domestic or foreign


currency borrowing is favourable, goes with the existing literature on currency carry
trading, and is based on historic quarterly excess returns (equivalent as currency
carry trading in Chapter 3.5.1) from 1990 until 2011 with the idea to borrow in FCU in
order to invest in EUR.

Equation 12 provides the formula of calculating quarterly excess returns whereas St


is the foreign currency exchange rate at the beginning of the quarter (respectively
St+1 at the end of the quarter, both in terms of FCU per EUR), iEUR the domestic
interest rate, iFCU the foreign interest rate and T for the number of calendar days (i.e.
discrete compounding on basis actual/360). The reasons for using discrete
compounding are the convention of interest calculation on bank loans and
comparable empirical studies on the payoff of carry trades use this approach. To
provide a fuller picture geometric mean returns are reported as well.

175
176

cf. Boss 2003: pp. 28 32, translation by the author


cf. Boss 2003: p. 17, translation by the author

- 46 -

Equation 12: Quarterly returns currency carry trading (EUR/FCU)

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.

The foreign exchange rates (midpoints) EUR/CHF and EUR/JPY (respectively


ATS/CHF and ATS/JPY prior to 1999, converted to EUR by 13.7603) are obtained by
OANDA and interest rates, as the three month LIBOR CHF and JPY and the three
month EURIBOR (respectively VIBOR prior to 1999) are obtained from Reuters.

The calculation is based on three strategies, basically borrowing in CHF respectively


JPY in order to invest in EUR, whereas each strategy consists of 87 non-overlapping
quarterly periods, and differ only slightly in the timeframe (lag in the starting and
finishing points) and therefore in the roll-over periods. Strategy 1 begins at the last
trading day of January 1990 until October 2011 (i.e. roll-over dates are the last days
in January, April, July and October), Strategy 2 starts with one month lag at the last
of February 1990 until November 2011 (i.e. roll-over dates February, May, August
and November) and finally Strategy 3 which starts in March 1990 until December
2011 (roll-over dates are March, June, September and December).

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

cf. Mooslechner et al 2007: pp. 34 36


cf. p. 9

- 47 -

Potential benefits of diversification are investigated by creating a 50/50 portfolio


which is funded at 50% in CHF and 50% in JPY, with rebalancing every quarter to
the target allocation.

4.5.2 Quarterly Returns


Figure 20 summarizes the statistic of quarterly returns for Strategy 1, starting on the
last trading day of January 1990 until October 2011.

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

OANDA, Reuters, OeNB, authors calculations


cf. Brunnermeier et al 2009: p. 324

- 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

OANDA, Reuters, OeNB, authors calculations

- 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

OANDA, Reuters, OeNB, authors calculations

- 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

OANDA, Reuters, OeNB, authors calculations

- 51 -

200
175
150
125
100
75
50
25
0

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

Figure 26: Excess return index 50/50 portfolio (Strategy 1, Strategy 2 and Strategy 3)

186

4.5.3 Cumulative Returns including Transaction Costs


While prior return calculations abstract from transaction costs, the following provides
graphically the excess return indices including transaction costs. Therefore the
indices are recalculated by deducting the fee impact investigated in Chapter 4.3 (i.e.
0.22% p.a. on a quarterly basis).

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

OANDA, Reuters, OeNB, authors calculations

- 53 -

200
175
150
125
100
75
50
25
0

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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).

4.5.4 Annualized Returns


The following reports results on annualized basis through compounding quarterly
mean returns, respectively multiplying the standard deviation by the square root of
four (according to the square root of time rule) for focusing on the Sharpe ratio
(henceforth SR).

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

OANDA, Reuters, OeNB, authors calculations

- 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

Figure 30: Annualized return statistics of Strategy 1, Strategy 2 and Strategy 3

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

cf. Burnside et al 2011a: p. 866


cf. Burnside et al 2011b: p. 515
192
cf. Burnside et al 2011a: p. 866
193
cf. Burnside et al 2011b: p. 515
194
OANDA, Reuters, OeNB, authors calculations
195
OANDA, Reuters, OeNB, authors calculations
191

- 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.

4.6 Profitability on CHF and JPY Borrowings in Austria


4.6.1 Calculation Approach
The lack of appropriate data makes it difficult to investigate total absolute profits of
Austrian private households on borrowing in foreign currency as substitution of the
domestic one (specific data on private household loans are available from 2002
onwards, and miss therefore some of the high profits in JPY borrowing in the years
before). Therefore the following calculations are based on foreign currency
borrowings of Austrian non-monetary financial institutions granted by domestic
monetary financial institutions. The primary data shows the amount of outstanding
debt denominated in CHF and JPY (but converted to EUR) at the end of each quarter
(starting at the last quarter of 1998 until the last of 2011).

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

OeNB, authors calculations

- 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.

Equation 13: Real debt on foreign currency borrowing

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.

4.6.2 Profitability of Foreign Currency Borrowing


Figure 33 exhibits gains coming from interest rate differential and exchange rate
movements. Not surprisingly, gains from interest rate differentials are comparably
small to profits and losses on exchange rate movements. As previously shown the
timeframe from 2003 until 2007 has been a very profitable period while some
quarters later on produced substantial losses (e.g. in the range of 3 and 4 billion EUR
within some quarters).

- 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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 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.

4.6.3 Private Household Exposure on CHF and JPY Borrowings


To get a rough idea how Austrian private households were exposed to the reported
results the following examines the size of private household debt denominated in
CHF and JPY in absolute money and relative to the whole outstanding debt
denominated in these two currencies. For statistical purposes the following excludes
debt from sole proprietors.

bn EUR
50

100%

40

80%

30

60%

20

40%

10

20%

0
2003

0%
2004

2005

2006

2007

2008

Absolute (left scale)

2009

2010

2011

Relative (right scale)

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

OANDA, Reuters, OeNB, authors calculations

- 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%.

Figure 40 shows equivalently the outstanding debt absolute and relative


denominated in JPY. While the absolute outstanding debt amount went down from
around 8 billion EUR to below 1.7 billion EUR the relative size decreased slightely
from 50% to 46%, as companies also decreased their JPY borrowing over this
period.

bn EUR
10

100%

80%

60%

40%

20%

0
2003

0%
2004

2005

2006

2007

2008

Absolute (left scale)

2009

2010

2011

Relative (right scale)

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.

However, deriving the profitability of Austrian private household foreign currency


denominated borrowings lacks appropriate data. Therefore the following calculation
is based on the relative share of foreign currency denominated private household
debt (excluding sole proprietors) on all foreign currency denominated debt in Austria.
The missing shares (prior 2003) are replaced backwards until 1999 with the earliest
available data from the end of 2002. At this time 35% of total CHF and 50% of total
JPY denominated debt is held by Austrian private households. Using the absolute
profits and losses for CHF and JPY borrowings reported in Chapter 4.6.2 and the
204

OANDA, Reuters, OeNB, authors calculations

- 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

OANDA, Reuters, OeNB, authors calculations

- 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)

Figure 43 summarizes the cumulative statistics of both currencies. In total, Austrian


private household foreign currency borrowers made a profit through lower interest
rate expenses of around 5.3 billion EUR and losses from exchange rate changes of 6
billion EUR, giving therefore a total cumulative loss of around 0.7 billion EUR.

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

OANDA, Reuters, OeNB, authors calculations


OANDA, Reuters, OeNB, authors calculations

- 65 -

5 Carry Trading Extended The Repayment Vehicle


5.1 Introduction into Private Household Borrowing - Extended
More than two thirds of Austrian private household foreign currency denominated
debt is constructed as balloon loans including a repayment vehicle (see Chapter 2.3).
Therefore the following chapter examines the idea behind investing money into a
savings plan instead of continuously repaying the outstanding debt via annuities.

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.

Plugging in the exemplary numbers results in constant quarterly payments of 1,817


EUR in total (938 EUR for interest expenses plus 880 for the savings plan of the
repayment vehicle). The exemplary foreign currency loan with continuous repayment
results in quarterly annuities of 2,022 EUR while the comparable domestic currency
denominated loan requires quarterly payments of 2.380 EUR (see Chapter 4.2).208 In
fact, the constructed balloon loan including a repayment vehicle offers 10% lower
quarterly payments compared to the foreign currency loan using annuity payments,
respectively 24% lower than the equivalent domestic denominated one.

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.

Figure 44 exhibits the comparison of (net) outstanding debt amount of standard


domestic and foreign currency denominated loans (as shown in Figure 14) versus a
foreign currency denominated balloon loan under the condition of quarterly payments
of 2.380 EUR for each strategy. However, the exposure of the first two loan
opportunities decreases during the lifetime of the loan, the exposure of the balloon

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.

5.2 Return Sources on a Balloon Loan including a Repayment Vehicle


However, the main difference to the carry trade strategy of borrowing substitution
(investigated in Chapter 4) is that under the substitution of the loan currency the
return is created by a cheaper foreign currency loan instead of a domestic
denominated one, i.e. a carry trade with implicit investing. In contrast, the strategy
including the repayment vehicle creates the return by borrowing in foreign currency
and explicit investing into a savings product. The fundamental difference is that the
first version already makes a profit (abstracting from exchange rate movements)
when the foreign borrowing rate exceeds the domestic one (base rate plus credit
spread and fees). In the second version the foreign currency borrowing rate has to
exceed the investment return.

Figure 45 exhibits an exemplary comparison between interest rates of domestic


currency (EUR) borrowing respectively foreign currency (FCU) borrowing and three
major asset classes (money market, long term bond market and equity market).

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

Money Market Money Market


Fund

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.

5.3 Risks on Balloon Loans including Repayment Vehicles


Equation 15 exhibits the portfolio value of a private household including the initial
investment of the loan proceeds (e.g. a house) plus the present value of the future
income minus the current market value of the debt plus the current market value of
the repayment vehicle.

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).

Figure 46 provides an overview of the long/short exposure of a foreign currency loan


including a repayment vehicle. The shaded area exhibits the exposure of the
currency substitution in borrowing (obtained from Figure 19) which is basically the
short position in FCU and the implicit long position in EUR (substituted loan
- 71 -

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 -

currency substitution, the borrower has to investigate exchange rate changes


between the borrowing and investing foreign currencies as well.

5.4 Costs of Balloon Loans


5.4.1 Credit Spread
One of the most important cost factors is the credit spread of the borrower. While
excess returns of equities and long term bonds are usually reported above short term
bills, a private household lacks the ability to take a loan at the risk-free rate.

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.

5.4.2 Impact of Transaction Costs on Balloon Loans


Equivalent to Chapter 4.3, transaction costs of foreign currency borrowing changes
the internal rate of return (i*) on the loan. Since the capital flow structure is different
to a loan with continuous repayments also the impact of transaction costs is slightly
different. Equation 16 provides therefore the formula to calculate the impact of
transaction costs.

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

cf. Fembek et al 2002: p. 108, translation by the author

- 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%

interest rate including fees

0.16%

0.07%

0.04%

0.04%

0.02%

Internal rate of return

Figure 47: Fee-impact on mortgage interest rate of a balloon loan

EUR

216

5.4.3 Fees and Taxes on the Repayment Vehicle


Fees on the investment products used as repayment vehicles are a substantial factor
for investigating real world returns.

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

cf. Hager/Kreindl 2012: p. 77, translation by the author


cf. Hager/Kreindl 2012: p. 78, translation by the author
222
cf. Jones 2008: p. 260, translation by the author
223
cf. Chalmers et al 1999: p. 13
224
cf. Malkiel 2000: p. 377, translation by the author
225
cf. Malkiel 2000: p. 377, translation by the author
226
cf. Bogle 2005: p. 37
227
cf. WKO 2012: p. 1, translation by the author
228
cf. WKO 2012: p. 2, translation by the author
221

- 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

5.5 Major Asset Classes


5.5.1 Money Market
Investing the proceeds from foreign currency borrowing into the domestic money
market would result basically in the carry trade returns already exhibited in Chapter
4.5. However, reported annualized mean returns of CHF borrowings are zero and of
JPY ones round 1% (not connected for costs, see Figure 30) are clearly not high
enough to cover besides transaction costs, fees and taxes (for domestic interest
income) a credit spread of around 1%. Furthermore a private household will receive
less than the 3 month domestic interbank rate for a three month money market
investment, since EURIBOR is an ask rate, and the household has to pay capital
gains tax on the gross interest income as well.

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

cf. WKO 2012: p. 3, translation by the author


cf. Bogle 2005: p. 36
231
cf. Ratschiller/Moschner 2011: pp. 11 13, translation by the author
232
cf. Ratschiller/Moschner 2011: p. 22, translation by the author
233
cf. Ratschiller/Moschner 2011: pp. 10 14, translation by the author
230

- 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.

5.5.2 Bond Market


Using bond market investments as repayment vehicle, foreign currency investors
generate besides the carry trade return a return coming from maturity intermediation.
The idea is to borrow on a short term interest rate in order to invest into a long term
interest rate. However, this exposes the borrower to the risks related to maturity
intermediation. Furthermore using long term investments makes it difficult for the
borrower to have enough flexibility, i.e. when carry trade returns are expected to get
negative the borrower faces difficulties of liquidating the investment product.

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)

Equivalent, Figure 49 shows the intermediation spread of Switzerland and Japan.


While in Switzerland the spread fluctuated all the time between around 0% and 2.5%,
the Japanese one decreased from a high level in 1994 and 1995 (between 3.5% and
4.5%) down to a low range between 0.5% and 1.75% from 1999 onwards.

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

Reuters, OeNB, authors calculations


Reuters, OeNB, authors calculations

- 78 -

Figure 50 provides an overview of the mean spread between 10 year government


bonds and the respective 3 month interbank interest rate (EUR denotes basically for
Austria). The result shows a very similar spread in all three countries.

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.

5.5.3 Equity Market


It is often assumed the highest expected return can be generated using borrowings
for investing into the stock market in order to generate the equity risk premium.

236

Reuters, OeNB, authors calculations


cf. Dimson et al 2011: p. 48
238
cf. Dimson et al 2011: p. 41
239
cf. Dimson et al 2011: p. 51
237

- 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

5.6 Empirical Stock Market Excess Returns


5.6.1 Calculation Approach
According to prior calculations on the excess return on foreign currency borrowing
(see Chapter 4.5) the following investigates the excess return on the MSCI World
index funded with borrowings denominated in CHF respectively in JPY from the view
of an EUR based borrower. Since prior investigation of the carry trade return is based
on discrete compounding (for the named reasons), results are here shown on the
240

cf. Siegel 2006: p. 30, translation by the author


cf. Dimson et al 2011: p. 31
242
cf. Dimson et al 2011: p. 6
243
cf. Dimson et al 2011: p. 48
244
cf. Dimson et al 2011: p. 41
245
cf. Dimson et al 2011: p. 51
246
cf. Dimson et al 2006: p. 29
241

- 80 -

same basis in order to keep consistency. However, geometric mean returns are
reported as well. Equation 17 exhibits the calculation approach.

Equation 17: Excess return on foreign currency loan funded investments

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.

5.6.2 Empirical Results


Figure 51 shows the summarized return statistics of the CHF funded MSCI World
investment. While arithmetic and geometric means are all positive, the standard
deviation is around 4 times higher for CHF, respectively almost 2 times higher for
JPY than under the carry trade excluding for stock market investments (see Chapter
4.5.2). Also minimum and maximum returns are substantially higher. Especially JPY
funded MSCI World investments exhibit an abysmal minimum return of around -40%
within the worst quarter. In general JPY funded MSCI investment returns are strong
leptokurtic and fat tailed.

- 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

Figure 52: Annualized return statistics of Strategy 1, Strategy 2 and Strategy 3

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

MSCI, OANDA, Reuters, OeNB, authors calculations


MSCI, OANDA, Reuters, OeNB, authors calculations

- 82 -

350
300
250
200
150
100
50
0

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

MSCI, OANDA, Reuters, OeNB, authors calculations


MSCI, OANDA, Reuters, OeNB, authors calculations

- 83 -

5.6.3 Empirical Results net of Costs


Since a private household borrower would not be able to borrow at the LIBOR flat
(i.e. excluding any credit spread) and has to pay taxes and fees on the investment
product as well, the following investigates the impact of these constraints on the
returns. In contrast to the previous calculation the following is based on the MSCI
World Net Index (i.e. dividends are reinvested after deducting capital gains tax). In
reality, investors would have to pay taxes on realized capital gains as well
(depending on the nature of the repayment vehicle). Furthermore the calculation
takes into account a credit spread on the foreign currency loan of 1% (plus 0.16% for
transaction costs) and the return gets lowered by 2% for fees on the investment
product (e.g. management fee, bid-ask spread, etc.). Note that, even though low cost
products like index funds or ETFs are available, they are not widely used by private
investors. Hence, the focus of the calculation is based on actively managed mutual
funds which exhibit even higher costs. And as empirical investigations show, that
average mutual funds return 2 percent points below index funds, 251 there is even
room left for an outperformance before costs on active management. The reason is
that the 2% are deducted from the index return itself and not from the return of the
index fund which also has to bear costs (e.g. management fee, transaction costs).

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

cf. Malkiel 2000: p. 377, translation by the author


MSCI, OANDA, Reuters, OeNB, authors calculations

- 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

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

MSCI, OANDA, Reuters, OeNB, authors calculations


MSCI, OANDA, Reuters, OeNB, authors calculations

- 85 -

350
300
250
200
150
100
50
0

Strategy 1: Jan. 1990 - Oct. 2011

Strategy 2: Feb. 1990 - Nov. 2011

Strategy 3: Mar. 1990 - Dec. 2011

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

MSCI, OANDA, Reuters, OeNB, authors calculations

- 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.

A survey of 2003 by the European commission reports that 92% of respondents in


Austria expect getting advice by the financial institution.256 Together with Germany
this is the highest level and far higher than the average of 74%.257 Therefore it might
be the case that private households in Austria rely more than the average private
household in Europe on advice from outside in their financial decision making
process.

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

Furthermore, a mystery shopping survey among 13 banks and 12 independent


financial advisors comes to the conclusion that independent financial advisors have
their commissions in the center of interest, while banks in general offer a loan which
is more accurate to customers needs and wishes.259

Additionally, in an environment of continuous commission flows, it might be unlikely


that financial advisors recommend their clients to unwind their repayment vehicle in
order to pay back the loan, even when advisors expect that this would be most
suitable for the client. More than that, a rationally acting financial advisor would in
order to increase commissions, recommend the client to make higher payments into
the repayment vehicle, if the investment product is expected to generate returns
lower than required to fully repay the loan at maturity, instead of direct loan
repayments. Financial advisors seeking ways to increasing commissions are also
incentivized to recommend their clients to take a higher loan than they need e.g. for
housing in order to pay the residual amount immediately into the repayment vehicle.

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

However, this mis-selling behaviour by financial advisors because of incentive


conflicts gets capped through the liability and reputational risk they face.

258

cf. CFA Institute 2009: p. 4


cf. Market 2007: p. 6, translation by the author
260
cf. Fembek et al 2005b: p. 66, translation by the author
261
cf. Hackethal et al 2012: p. 521
259

- 88 -

6.2 Client Independent Financial Advisor Relationship


Independent financial advisors (i.e. self-employed financial salesman) played a
crucial role in the distribution of foreign currency loans.262 An explanation of this
behaviour might be provided by the involved sales commission.263 As a survey
shows, foreign currency loans play an important role on the profit situation of the
whole industry,264 and around 90% of respondents actively offer them as balloon
loans.265 Furthermore, financial advisors fear a large drop of their business activities
after the de facto prohibition of foreign currency loans.266

However, while for arranging a loan, an independent financial advisor gets a


commission by the lending bank (typically a share of the administrative charge of the
loan), selling a balloon loan in combination with a repayment vehicle generates a
commission from the insurance company as well.267

As a model calculation (based on real life numbers) of an endowment life insurance


with monthly payments of 100 EUR for 24 years, shows that the sales force receives
in total a commissions of 1.350 EUR.268 A comparable variable life insurance
generates commissions for the advisor of around 1.754 EUR.269 Levering up this
numbers to a contract size with total insurance premium contribution of 150.000 EUR
results in commissions between 8.400 EUR and 11.000 EUR (under the assumption
that commissions increase linear by the contract size, i.e. a percental commission).
However, additional bonuses and kick-backs (monetary or non-monetary) to the
sales force for reaching a specific target (e.g. cumulative yearly contract size) might
increase the total profitability of a specific contract substantially.

Some specific investment products have delivered outstanding commissions to the


sales force. For example, British life insurances exhibit substantially higher
commissions (doubled as much) for the sales force in continental Europe than in

262

cf. Boss 2003: p. 16, translation by the author


cf. Beer et al 2008: p. 111
264
cf. Cocca 2010: p. 4, translation by the author
265
cf. Cocca 2010: p. 20, translation by the author
266
cf. Cocca 2010: p. 31, translation by the author
267
cf. Nordberg 2003: p. 128, translation by the author
268
cf. Hager/Kreindl 2012: p. 64, translation by the author
269
cf. Hager/Kreindl 2012: p. 66, translation by the author
263

- 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

6.3 Client Bank Advisor Relationship


Besides commissions which are also an important part of compensation schemes of
bank advisors, the sales control system is a strong non-monetary incentive to guide
bank advisors.274 Furthermore, bank advisors are often incentivized to prefer in
selling products produced by the bank itself or by subsidiaries.275

It is evident, that the banks compensation scheme is designed to make advisors


acting in the banks interest. Therefore, if the often raised argument of a lower profit
margin on foreign currency loans in contrast to domestic currency ones, bank
management would strongly support (through the sales control system or the
compensation scheme) the sale of conventional loans. Since survey data shows that
30% of foreign currency borrowers received their first information on this product
through a bank advisor,276 the rational would be that banks face also an economic
incentive for selling foreign currency loans. If credit spreads on foreign and domestic
currency loans are fairly priced (i.e. both opportunities are equal by profitability to the
bank), the lending bank has the possibility to increase their income through foreign
270

cf. Hager 2006: p. 66, translation by the author


cf. Kistner et al 2009: p. 48, translation by the author
272
cf. Fembek 2009: p. 42, translation by the author
273
cf. Cocca 2010: p. 17, translation by the author
274
cf. Hackethal et al 2012: p. 519
275
cf. Hackethal et al 2012: p. 519
276
cf. Market 2003: p. 2, translation by the author
271

- 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

- 92 -

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.

CHF denominated borrowing of non-financial institutions between 1999 and 2011


generated a total cumulative loss of approximately 5.6 billion EUR (sum of the gains
from lower interest expenses and the exchange rate losses).290 In contrast JPY
borrowings exhibit a profit of equal size (i.e. foreign currency borrowing has been a

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

In general it is questionable whether it is a very wise strategy to use a safe haven


currency like CHF for borrowing, because due to the very low inflation rates it has
been a permanent candidate for appreciation. And going short an asset with
countercyclical character and simultaneously long in assets exposed to market risk
leverages expected losses in market downturns. This strategy is very speculative in
nature and might stand in contradiction to the idea of proper diversification of private
household risk and requires a favourable combination of strong nerves and deep
pockets. However, if investors are purely interested in long term results, deciding to
ignore short term fluctuations, they should avoid using borrowed money.300 Using
alternatively long term risk-free assets as repayment vehicles exposes the speculator
to well-known risks associated with maturity intermediation.

Conflicts of interest are in general pitfalls in implementing a borrowing strategy and


might contribute to the understanding of the risky borrowing behaviour of Austrian
private households. The commission based compensation might offer a strong
incentive to financial advisors for preferring balloon loan constructions in their
294

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 -

recommendations, since the sale of investment products generates by far higher


commissions than selling a loan only. However, within an environment with such
conflicts of interest, investors make mistakes not by coincidence and it is highly
probable that they wrong decisions happen frequently.301
Summing up, neither borrowing substitution nor using balloon loans with repayment
vehicles have generated attractive risk adjusted returns but exposed private
households to substantial risks. Moreover the leveraged investing into the stock
market significantly decreased the wealth within 22 years.

7.2 Fields for Future Research


Even if this paper succeeded provide a comprehensive overview including relevant
results to assess the profitability and at least partially addresses the question
regarding the suitability of foreign currency borrowing to Austrian private households,
there is enormous room for future research.

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.

Understanding which segments of private households used foreign currency loans to


build or buy a more expensive house would help to address the question of the
financial knowledge of using such a speculative product. However, there is evidence
that potential borrowers are primarily focused on the loan size they could take
according to the willingness of the lender instead of what they should take due to
their personal situation.302 Therefore, when borrowers are confronted with lower
monthly expenses on the loan (as foreign currency loans do) they might take on

301
302

cf. Ariely 2010: p. 15, translation by the author


cf. Ariely 2010: p. 371, translation by the author

- 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

Furthermore, the saving and consumption behaviour of private households using a


foreign currency loan could address the question of the impact on the domestic
economy (i.e. it is often assumed that the lower interest expenses positively affected
domestic consumption). Due to an increase of stock market and real estate valuation,
private households might have fewer reasons to save since they feel wealthier
respectively they might view their growth of asset values as part of their savings.305 If
this is true, foreign currency borrowing has due to the leveraged exposure to market
risk a pro-cyclical effect on domestic consumption.

7.3 Final Remarks and Lessons Learned


Speaking generally, extrapolating current conditions into the future (linear or nonlinear) under the assumption of a deterministic world often delivers impressive ex
ante results (as here lower expenses on the borrowing). This holds especially, when
the purpose of plugging in numbers is to convince potential clients about using an
innovative investment product. However, history teaches that surprises are endemic
in the world of finance.306 However, observed historic returns are not very useful in

303

cf. Ariely 2010: p. 374, translation by the author


cf. Shiller 2000: p. 179, translation by the author
305
cf. Akerlof/Shiller 2009: p. 193, translation by the author
306
cf. Bernstein 2007: p. 422, translation by the author
304

- 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

cf. Jones 2008: pp. 100 107, translation by the author


cf. Sharpe 2008: p. 261, translation by the author
309
cf. Graham 2001: pp. 26 27, translation by the author
310
cf. Graham 2001: p. 26, translation by the author
311
cf. Wailand/Fembek 2009: pp. 133 134, translation by the author
312
cf. Galbraith 2010: pp. 32 33, translation by the author
313
cf. Shiller 2000: p. 264, translation by the author
308

- 98 -

implemented against credulity in all spheres of human life would lead to an


overwhelming and ineffective flood of legislation.314

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

cf. Galbraith 2010: p. 116, translation by the author


cf. Graham 1963: p. 65

- 99 -

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OeNB: Anteile an den Bestnden in %. Anteile an den gesamten Ausleihungen in %.


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