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Characterizing carry Efficient carry strategies involve buying and selling dynamic portfolios of currencies with certain risk characteristics. Carry strategies are supposed to work better over long investment horizons, so that the cushion provided by the carry compensates for the currency volatility through mean reversion. Here, we analyze carry from a different perspective, as our goal is to identify standalone attractive carry opportunities. We define the investment horizon to end 1Q17. We sort currencies based on risk-adjusted carry. We then characterize the factor exposure of currency returns, isolating global and idiosyncratic sources of risks, in order to identify smart carry trades that are not highly exposed to a massive re-pricing of global factors, such as US rates, USD, commodity prices and global risk aversion. We identify carry trades that have low exposure to global factors, in particular the USD factor, and offer attractive risk-rewards. Not surprisingly, purely based on carry considerations, EM currencies appear more attractive than DM ones, which are mostly candidates for funding currencies. However, carry trades returns are highly volatile, exhibit negative skewness and fat tails. Even controlling for different measures of risk such as volatility or maximum drawdown, and according to this criteria only, we find that EM currencies are the most attractive, in particular ARS, BRL in LatAm, RUB, TRY and ZAR in EEMEA and INR, IDR and CNY in Asia (Chart 63). Even though volatility and drawdowns can be useful measures of risk, they don’t say much about the exposure to different risk factors. Since carry trade strategies are usually very sensitive to global factors, we study the cross sectional exposure of currencies to key global factors: commodity prices, global risk aversion and US yields (as a proxy of global yields}. We report the R2 of regressions of two years of weekly returns on the above mentioned global factors, for the last two years and the years 2013-2014 for the sake of comparison (Chart 64). We find that currencies in LatAm and EEMEA are more exposed to global factors than in Asia. Interestingly, LatAm and EMEA currencies are more sensitive to shocks in commodity prices and risk aversion, while in Asia the shocks to monetary policy are the most important ones (Chart 65). Within DM currencies, AUD and NOK are the two currencies most exposed to global factors. Ideally, we seek for currencies with high risk- adjusted carry and low exposure to global factors. Under such a metric, ARS, BRL, RUB and INR stand out as the best investment currencies, while EUR, CHF, JPY, KRW and TWD are the best funding currencies. However, this filter is not enough in the current volatile environment. Chart 64: LatAm is more exposed to global factors than Asia Chart 65: Sensitivity to global factors across regions 08 nn 2 06 Depend on global factors Normalized beta of global factors m Monetary 06 = Commodities 05 mw Equities mRSQ'6 @RSQ'14 04 04 03 0.2 02 0 01 -0.2 SSSESANS SO ZHOF SOSH AReSHRa reas“ EESTS = SSEEEZNS2O2H SF SSS GRG SSE RE PALS“ EEBTSS Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg Bankof America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 37 Merrill Lynch HOUSE_OVERSIGHT_014767