How to Measure Risk Appetite

The amount of risk traders are willing to accept is an important factor that drives FX trading, and Eric Viloria tells how to gauge risk appetite and stay on the proper side of the market.

All traders and investors worry about risk, but in currency trading, they talk about “risk sentiment” and “risk appetite.” What do those terms mean, and how does it affect currency traders?

Our guest today is Eric Viloria from FOREX.com, so Eric, first of all, what is risk sentiment?

Risk sentiment is the attitude of investors towards putting on risky positions.

So when you have risk appetite, that means they’re more inclined to take on more risky trades. And when there’s risk aversion, they’re looking for the flight to safety; they’re looking for a more safe-haven place to put their capital.

So what affects this? What makes someone want to take on more risk in this global environment?

A lot, actually, but the main thing I would say would be economic growth. So when there’s more growth—and not just growth at this time, but expected growth in the future—when that’s happening, then investors are more likely to put on risky positions. 

Also…when things are volatile, that is related to more risk; then investors are more risk averse. 

Now typically…when people are not being so risky with their investments, (the US dollar) has been kind of the safe-haven currency. That’s changed a little bit recently because people worry about the US debt. 

Is there a change long term (and short term) over which of these currencies is considered the “safe” one at the time?

Well some of the safe-haven currencies right now are the US dollar, although there are concerns about raising the debt ceiling. It’s likely that they will do that. We’ve been in this position before where they had to raise the debt ceiling and it’s been done in the past, but some of the other safe havens are also the Japanese yen; (the) Swiss franc, of course, has been traditionally a safe haven; and gold as well.

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So how do I then use this information if I know that the risk appetite is gaining strength? Is there a way I can use that information to place a trade myself and profit from that information?

Sure. So if investors are having more of an appetite for risk, then we can expect the safe-haven currencies to weaken.

So what happens generally is because the US dollar has such low interest rates right now, it’s being used as a funding currency for what’s called the “carry trade.” 

So if there’s more risk appetite, investors are more likely to borrow in the US dollar and use those funds to invest in riskier holdings elsewhere in the world, so that means they’re going to have to convert that currency from US dollars into riskier currencies.

Alright, so they’re borrowing at a lower interest rate and then investing it in something that’s going to get them a higher interest rate, but also a little more risk perhaps.

Exactly, and then they’re looking to make a return off that differential there. 

So when markets are risk averse when there’s more turmoil, and whether it’s geopolitical—such as unrest in the Middle East, or if China indicates that it’s looking to tighten rates to slow down growth because there’s such a large engine of growth for the global economy—then investors are going to become more risk averse, so they’re going to have to unwind those carry trades, meaning they’re going to have to buy back dollars in order to deleverage.

And probably the most famous case of that is the Japanese yen trade and the unwinding of that carry trade.

Correct, yes. We saw a massive deleveraging of the Japanese yen just a couple of years ago during the crisis.