The relation between FX carry, vol and $DXY -

One of the oldest correlations in financial markets is the DXY-Equity market correlation. We all know it, but very few understand why this correlation exists...

It wasn't too long ago when FX market was dominated by carry trades

where investors borrowed in low yielding currencies and invested in high yielding ones (essentially short LY, Long HY). just think of AUDJPY long, USDMXN short or any other combination for that matter, to understand how this mechanism works...

In stale markets macro/FI funds would sell FX fwds and "sit" on the carry... that worked great, until risk sentiment got dented... when equities turn lower, the initial market reaction is to unwind as much as we can and be liquid, especially when we are short USD (and need

to meet USD margins). This is why USD (or JPY for Japanese investors ) are considered "safe havens". This is also why volatility trades at premium in HY currencies.

While most vol traders focus mainly on exploiting RV/IV, one cannot ignore the risk-off premium embedded

Let's think about the following example, we borrow in EUR at 0% and put in in HY (say TRY) for 14%/ann. Now we lock 14% yield, but the problem is that when sh*t hits the fan the TRY can easily weaken 2-3%/day, which eats about 20% of our annual return, so we want to protect it

the easiest way to do that is by buying call options, but as everyone is on the same trade it will trade at a premium. The question is "how much premium should we agree to pay to protect our position"..

This is where vol traders can profit.... when a vol trader looks

at a carry trade he/she should not look at the rv/iv relation, but rather the Vol-to-Carry ratio. If your protection on a carry trade is fair (or cheap) in vol terms, there are many ways to structure a good carry trade via options (which yields in a very good risk-reward payout)

Which is why there is much more to vol trading than looking at the spot dynamic - volatility - skew complex...

@saeedamenfx @salr_nyc will probably have much more inputs on this super interesting topic