Wednesday, February 18, 2009

Revisting the Yen Carry Trade Mechanics

At this post on Brad Setser's blog in February 2007, you see an interesting discussion of the yen carry trade size and mechanics, which I’m re producing below. (The content is from the RGE monitor web site)

Andrew Rozanov of State Street knows a thing or two about how official institutions manage their money (that is a big part of his current job) and a thing or two about Japan (he was based in Tokyo for some time). In response to my previous post, he noted that much of the yen carry trade is now done through the swaps market – or off balance sheet. Hedge funds don’t really need to “borrow” yen and then buy higher yielding currencies – they do the same thing in the derivatives market, or pay a bank to do it for them. I have – with his permission – reprinted his comment below. It inspired a nice discussion.
UPDATE: State Street also seems to know a thing or two about the size of the carry trade. See the FT.
I took a number of things away from the discussion:
1) The obvious, what happens off balance sheet matters. The absence of strong growth in cross-border yen lending isn’t evidence that folks aren't betting on continued yen weakness – or that interest rate differentials will remain large enough to offset any uptick in the yen.
2) A trillion is probably a bit too high an estimate of the size of the yen carry trade, at least if we are talking about bets from the “leveraged” hedge fund community.
3) We shouldn’t forget about leveraged Japanese day traders … who, in aggregate, have become big players. Fx accounts with generous margin are the rage in Tokyo.
4) It is hard for competitive money managers to be on the sidelines and avoid putting on various kinds of carry trades right now.
Andrew Rozanov writes:
“as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...”
I would note that volatility is also low for some emerging market currencies. Volatility in the Brazilian real/ dollar, for example, has collapsed – because the central bank has resisted market pressure for further appreciation in the real. The same thing incidentally happened in Turkey in 2005. Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money. It probably isn’t an accident that Brazil added over $5b to its reserves in January. There are a lot of different cross-currency carry trades out there that have attracted a lot of attention.
Andrew Rozanov’s comments are reprinted in full below
Andrew Rozanov:
I would like to commend those astute commentators who pointed out the direct relevance and central role of the forward currency swaps market in facilitating carry trades. It is arguably the easiest and most preferred method to put on a 'carry trade' by the leveraged community. It was described several years ago in a book written for a Japanese audience by a former Moore Capital trader, Ken Shibusawa, who currently runs his own hedge fund advisory firm in Tokyo (Japanese website for his company: According to him, essentially the press has got it all wrong. Yes, the underlying economics of a typical carry trade is to 'borrow' in low-yielding currency (e.g. the yen) and then 'lend' on in higher-yielding currency (e.g. the dollar), but when we discuss the actual mechanics of it, hedge funds and other highly leveraged players typically would not engage in any actual borrowing or lending. To the extent a hedge fund would consider putting on such a trade at all, it would most likely do it in the following way, or some variation thereof (we use US$/JPY levels as in Ken Shibusawa's example in the Japanese book): Step 1. Buy US$ / Sell JPY in the spot market (say, at 120) Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120) Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50) Step 4. Buy UST in the spot market Step 5. Borrow US$ against UST in the repo market Some comments are in order. 1. A typical currency forward swap is step 2 + step 3. However, if that's all you do, you will be expected to deliver your US$ for settlement on T+2. But remember, we are looking at a hedge fund, who does not have the money to deliver and who wants leveraged carry. Thus, he needs to create this exposure with as little initial cash outlay as possible. The best way to do that would be to take an outright forward position in the market. 2. An astute observer will have noticed that the cumulative effect of steps 1 through 3 is precisely to create such an outright forward position, whereby our hypothetical hedge fund is now short the yen and long the dollar at 118.50 on a 3-month horizon (in other words, the hedge fund promised to pay 118.50 in 3 months time for an asset which is currently trading at 120 - and the lower the US$/JPY volatility, the higher the chance that the forward contract will have converged at or around the original spot price of 120). 3. But if a hedge fund wants an outright forward position, why go through the hassle of steps 1-3? Well, it all has to do with costs and liquidity. Apparently, it is cheaper and easier to put on such a position in the currency swap market rather than as an outright forward - as the market supporting corporate and 'real money' hedging activity, it is the most liquid. 4. Notice how the trade is structured in two separate legs. There is the FX market leg, where the hedge fund puts on a position to earn the carry from the interest rate differential in the two short-term markets. Then there is the UST leg, which is a completely separate transaction: longer duration US Treasuries are purchased to earn a higher yield, but they are financed in the repo market (of course, this example assumes a 'normal' upward sloping yield curve in the US). So if (and it IS a huge if) all goes as planned in the US$/JPY and UST markets, the total carry earned on the trade is the sum of FX market carry (i.e. short term interest rate differential) and UST market carry. Another way of putting it: the hedge fund earned money from two major risk sources: currency mismatch risk and duration mismatch risk. 5. In his book, Ken Shibusawa makes an interesting observation: many press commentators focus on what they can trace in the spot markets (i.e. step 1 and step 4), and often do not pick up on simultaneous transactions in derivative markets (i.e. combination of step 2 & 3, step 5). Thus, the tendency is to interpret this as hedge funds borrowing yen and selling yen spot, thus procuring dollars and then investing these dollars in long maturity UST). While the underlying economic logic and principle is the same, the mechanics are totally different. 6. Ken Shibusawa quips in the book that while much press attention at the time was focused on global macro hedge funds, it was probably relative value shops that were particularly keen on putting on massive yen carry trades in 1997-98, following the relative success of their "Japan risk premium" carry trades in the previous years. One final comment from me: as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...

And, for those of us without the financial sophistication to understand why anyone would both buy US$ for yen and sell US$ for yen in the spot market, Andrew noted:
Let me try and answer your question about why go through steps 1 and 2 by considering the other options. 1. If you do only step 1, you are going long USD and short JPY in the spot market. There are two problems with this approach as far as leveraged carry trades go. First, it's not leveraged - you will need to come up with the entire notional amount of JPY to settle this trade in two working days (T+2), so you're not really 'borrowing' anything. Secondly, you're not really trading for carry. Instead, you're putting on a directional bet: you buy US$ at 120 and hope it appreciates (or JPY depreciates), but you're not picking up any interest rate differentals. Incidentally, this type of trade typically favours high volatility environment - remember, volatility cuts both ways, so if you want to make money from a large swing up in the dollar (or swing down in the yen), you would be implicitly betting on high, not low vol. Carry trades, on the other hand, are typically low vol trades: any additional depreciation of the yen would be icing on the cake, but your main bet is that the world stays stable and predictable while you earn your carry on a leveraged basis (i.e., interest rate differential multiplied by leverage). 2. What about taking only steps 2 and 3 - i.e., the foreign exchange swap? The good news is this gives you carry: you buy 120 yen for every dollar now (on T+2) and at the same time contract to sell the newly acquired yen in 3 months' time, such that 118.50 buys you a dollar - in other words, you sold the dollar now at 120 and bought it back in 3 months at 118.50, earning the carry in the process. But the bad news is that, just like in the first comment above, you do not get any leverage, since you will need to provide an initial cash outlay on T+2 to settle the leg in step 2. 3. Why not forget steps 1 and 2 altogether, and just go for step 3? This is entirely legitimate and certainly doable. In the FX market, such a transaction is called an 'outright forward'. You agree with your counterparty bank to go long USD and short JPY based on today's spot price, but with settlement in 3 months' time - you will negotiate and agree the spot price, and then the bank will adjust it by the interest rate difference. No cash flows occur on T+2, you have effectively secured a leveraged position, and you've bought US$ at 118.50 in 3 months. Voila! The only reason you would consider doing something a bit more convoluted (like going through steps 1 to 3 above) is if it helps you save costs and earn even more money. And in competitive markets like FX you get the best prices and execution where the liquidity is the deepest. And the liquidity of spot and FX swap markets has always been (and I believe still is) much better and deeper than in the outright forward markets. Just have a look at Table B1 on page 5 of the BIS Triennial Central Bank Survey at the following link (last survey done in 2004):
Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee argued that these are notional numbers, so they only give a loose idea of real exposure. He also noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.

Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee noted that these are notional numbers, so they only give a loose idea of real exposure and noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.
I urge everyone to visit the BIS site and look up the relevant FX forward data for yen. The amounts have jumped very substantially from $2.3 trillion to $3.8 in 5 years. A big part of the increase has come in just 6 mos., going from $3.1 to $3.8 trillion between Dec. 2005 and June 2006 (latest available data).
Tmcgee cautioned:
I think $1 trln is a slightly ridiculous number, even if you include the sheer Japanese foreign asset holdings that don't really constitute carry trades per se, just a hunt for higher yields. Also, the BIS derivatives data gives some clues on potential size of carry trades. But I believe they also are all notional numbers, like the US OCC data, which means they're always growing at a fairly rapid pace -- because both sides of the trade are counted. The funny thing is now people are freaking about the size of the carry trade even though one of the supposed culprits of the unwinding of carry trades last april/may (incorrectly) -- a drop Japan's monetary base from the BOJ ending quantitative easing -- is still shrinking 21% yr/yr. and other BIS data -- reporting banks' cross-border positions vis-a-vis all sectors, by domestic and foreign currency -- shows no explosion of yen liabilities among major global banks.
Reporting bank yen cross-border positions vis-a-vis all sectors (blns USD) liabilities:
Domestic currency: December 04: $240.9; Sept 06: $235.9Foreign currency : December 04 $433.1; Sept 06 $457.6 We know the IMM speculative yen short data, so we have a vague since carry trades are popular. But as the Wachovia anlaysis points out, the evidence is far from compelling. ….
Also, no one seems to mention the role of Japanese FX margin trades in the carry trade. Check out data from the Tokyo Financial Exchange, which gives just a small peek into the explosion of margin trading here. These margin traders are quick to take profits when cross/yen hits new highs, but also buy the higher-yielding currencies (like the Aussie, on serious leverage) on any sharp pull-backs. And since so much money is waiting in Japan for moments of yen strength to invest abroad, it tends to put a floor under not only dollar/yen, but also euro/yen and sterling/yen …
BSetser edits: Data presentation edited for clarity, punctuation added.
And Cassandra always has a thing or two to say about the yen and yen carry trades.
Even if Tmghee is right and total carry trade exposure is significantly under $1 trillion, it scale of the carry trade seems to have increased significantly recently. And a lot depends on how the capital outflow from real money Japanese accounts over the past few years should be interpretted. Is it international diversification, money that is unlikely to return to Japan should relative interest rates change and/ or the yen start to appreciate? Or is it a bit more fickle, and perhaps be inclined to act a bit like leveraged money should conditions change?
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In the FX forward swaps market there are no "notional" amounts. All amounts are real and outstanding. If you put on a dollar/yen swap trade for $100 million you have to deliver $100 million in cash and receive the equivalent in yen, in cash, on spot settlement date. When the forward date comes, you will return the yen and receive back the dollars, again real money flows. This is not an option or futures trade, but a real swapping of large amounts of money. The amounts outstanding are thus very important and indicative.
Reply to this comment By Hellasious on 2007-02-04 16:32:32
hellasious -- would you mind if i made use of your comments on the preceding post in this post? My sense was that tmghee was arguing that "notional" amount may not reflect the banks ultimate risk -- take an example I happen to know well. Turkish banks were keen (in 05) to swap $ for long-term lira. International investors took a generally unhedged lira position in this swap (the banks that did the swap did so more their hedge fund clients ... who wanted more lira duration than was available in the government bond market). The turkish banks had $ to swap from their domestic dollar deposits so they were hedged, and they used the swaps to finance a fraction of the long-term mortgage lending. So the turkish banks effectively had offset both legs of the swap -- they had $ and long-term lira liabilities on balance sheet, and they used the offbalance sheet swap to match the two. that may nor may not be relevant here -- i generally know more about how folks manage their EM exposure than about stuff among the g-10.
Reply to this comment By bsetser on 2007-02-04 17:23:12
Dear Brad, You are welcome to use any comments you find useful. The banks' ultimate risk may not be direct market risk, as such, but credit risk. Bank A's dealing room may be running a perfectly matched book, but a crucial question is who is on the other side of the trades. If other large banks, then they are 99% fine - but no one can make any money that way, of course. It would be as if a bookie laid every single bet he got against another reputable bookie, instead of running his own book. There are only two ways for a bank's dealing room to make money: taking proprietary positions for the bank's own risk (gambling) or taking advantage of customer flows to make a spread (acting as bookie). Under most circumstances, bank dealing rooms are not so much gamblers as bookies - they just want to make the vig. It is therefore crucial for them to pick their customers with care because, unlike the heavies, they cannot threaten their customers with permanent visits to the aquatic domain if they fail to make good on their losses. The phenomenal rise of hedge and private equity funds has increased the systemic appetite for risk - there are many more gamblers out there willing to bet and that is why, pari pasu, the price of risk has collapsed (low risk premiums). Many large banks, seeing an opportunity, have jumped in with "three feet": a) They act as bookies on more and larger bets (more vig). b) They loan margin money to their "prime" hedge fund and private equity customers to make more and bigger bets (loan sharking). c) They take advantage of large customer trade flows, trading along with them for their own account and risk (like a bookie betting alongside a large gambler). Obviously (b) generates more (a) - and that is where most of the risk resides. For as long as the customers keep winning the process generates huge and increasing fees, interest income and trading gains for the banks own P&L. But if, for whatever reason, gains become losses and the customers cannot meet margin calls then the downward spiral begins. Everyone can easily understand what this means. Even a cursory examination of how debt has exploded in the past few years, particularly that of the financial sector, points to serious leverage being responsible for pumping up all asset prices. The yen carry trade is but a part of this process. Regards
Reply to this comment By Hellasious on 2007-02-05 02:25:14
Call me dumb, but I still fail to see how doing step one and two will give any leverage? Assuming step one and two are equal and opposite (EaO) transactions, their aggregate effect will be 0 (in fact, less due to spread and internal processing costs). On T+2 I will still have both USD and JPY inflow and outflows (matching, assuming no spread). Transacting two EaO spot transactions and making money out of it seems to me like a financial perpetum mobile?
Reply to this comment By Guest on 2007-02-05 06:14:30
hey brad -- please feel free to use whatever you find helpful. and to andrew -- fair enough on the japanese household assets. i see that on the boj flow of funds data, the amount of household money in japanese investment trusts (mutual funds) rose 33.6% yr/yr as of sept 2006 to 59.68 trln yen ($493 bln at a Y121 rate), a record high. and most of the new growth is in foreign assets. so including such funds with that of margin traders (though still comparatively small), maybe $1 trln is not so far fetched. i just find the fears about the yen carry trade speculative fervor a bit far fetched, in part because there have been several shake-outs of such trades in the past two years to keep anyone holding such positions on their toes (and i'm talking purely in yen terms -- perhaps a wider basket of carry trades including yen/Swiss franc/etc helps protect such trades). on the BIS data, i'm still not sure. i can't see how the massive yen carry trade would elude such bank lending stats. which jibes in tokyo about the difficulties foreign banks have tapping the overnight call market at times, though that may just be the difference between on balance-sheet and off/OTC, as mentioned. what's also weird is how the gross market values of OTC FX derivatives have shrunk on the BIS data between 12/04 and 6/06 even as notional amounts have risen sharply. and the biggest risers notionally in percentage terms are the aussie and kiwi (+54.5% and +193%), and the yen at 34.4% even as the euro grew 29.0% and USD 23.5%. here's what the san francisco fed had to say about it: the BIS itself was more circumspect last year. i think the big fear is leverage. that's what 1998 was all about. i think there is leverage this time, but not nearly that severe. and there is a big japanese domestic story that explains the yen's weakness, that is getting branded a little too easily as the gigantic and potentially world-wrecking yen carry trade. cheers
Reply to this comment By tmcgee on 2007-02-05 07:15:20
Asian Central Banks attempt to combat Asset Bubbles Not only did last year's higher interest rates fail to curb overinvestment, they may even have helped draw in all that cash. The People's Bank of China raised its benchmark rate twice last year; while higher rates kept consumer prices contained, they encouraged even more investment and growth by offering enhanced returns. China's M2, the broadest measure of money supply, rose 16.9 percent to 34.6 trillion yuan ($4.46 trillion) in December, the highest since figures became available in June 1998. In Thailand, M2 in November reached a record 6.92 trillion baht ($197 billion). China's rate increases last year failed to cool an investment boom that stoked the fastest growth since 1995. The central bank also increased the amounts banks have to set aside as reserves four times since June to discourage excessive lending. That helped slow money supply growth to 16.9 percent in December from 19.2 percent in January 2006. Even so, urban real estate prices in China rose faster. Prices for apartments and offices in 70 cities increased 5.4 percent in December from a year earlier, after a 5.2 percent gain in November, according to the National Development and Reform Commission. Central bank Deputy Governor Wu Xiaoling said Jan. 25 in Davos, Switzerland, that China will tighten environmental controls to rein in overinvestment. Such measures ``would only slow growth marginally,'' says David Cohen, an economist at Action Economics in Singapore. ``Short of establishing currency controls like we've seen in Thailand, I don't think measures to reduce property prices across the region will have much of an impact,'' says Eugene Kim, chief investment officer of Tribridge Investment Partners Ltd. in Hong Kong, a hedge fund managing about $100 million. ``The wealth out there needs to go somewhere.'' ``There is too much money globally chasing meager returns, and the liquidity has found its way to asset markets,'' says Arjuna Mahendran, chief Asia strategist at Credit Suisse Group in Singapore. ``There is no perfect solution. If the flows aren't absorbed, you'll have a crisis at some stage.''
Reply to this comment By Dave Chiang on 2007-02-05 08:12:01
"Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money." That's why I referred to the phenomenon as a strange attractor when I worked up my follow-up commentary on your post yesterday. Dave Iverson Economic Dreams-Nightmares
Reply to this comment By Guest on 2007-02-05 09:04:54
See also the blogger "Macro Man" and his possibly-sour-grapes antithesis (he went short Yen/$ recently) which pulls together a good amount of data to assert Yen carry is really no big deal right now. Viz and ignore the title.
Reply to this comment By wcw on 2007-02-05 09:56:58
Brad, you were puzzled by why the Chinese currency might become a carry currency rather than a target. Some reasons for the Yuan being used by some in the carry trade are pointed out in Bloomberg editorial:
Reply to this comment By OldVet on 2007-02-05 12:41:00
I saw the mukherjee piece, and was still a bit confused ... it feels like a mix of an onshore/ offshore artibtrage (offshore RMB pay less than onshore -- so a good funding currency; onshore = 2% plus and the currency appreciation) and a bet that the RMB will appreciate by less than other asian currencies (destination currencies) with a bit more carry. OK, fair enough. but it also seems like the investment and commercial banks have a lot of demand for folks who want RMB simply for the appreciation (now that the pace seems a bit stronger), and are looking for someone else who wants to, in effect, sell RMB ...
Reply to this comment By bsetser on 2007-02-05 13:34:04
Anyone care to explain "Guest's" question about they steps 1 and 2 offer leverage. I agree with Guest that they seem to offset at T+2 and it is not clear to me how leverage is achieved through the first two steps. If anyone truly understands this, an explanation would really be appreciated.
Reply to this comment By Gamma on 2007-02-05 15:26:33
a couple of comments on macroman -- (the content, not the title ... ) 1) Re: Why isn't Japan's trade surplus bigger -- a) lags -- yen wasn't so weak not so long ago (04). watch 07 b) oil c) yen is only weak v. rest of the g-3. it isn't obviously weak v. the yuan d) don't forget about japan's exploding income surplus 2) positioning the macro funds that I know of tend to fund their long Nikkei positions with yen ... their hedging as the Nikkei rose was supposedly a source of pressure on the yen (i.e. higher yen = more unrealized profits in $ that needed to be protected v. slides in the yen). but that was an 05 story, not an 06 story what strikes me as different this time around is that I get a sense that -- as a result of diversification -- there are a lot more Japanese short yen positions (long kiwi, long us bonds, long european stocks, long you name it) than before. Mostly real money. but still mostly unhedged. If folks suddently started to hedge v. $ weakness or euro weakness v. the yen, that could potentially move the market. and, as for the limited on balance sheet cross border yen lending, i trust andrew rozanov. this is now done primarily thru swaps. finally, there is a lot of anecdotal evidence and market evidence (look at the swiss franc as well as the yen, and at destination currencies like the real) that lots of folks woke up on January 1 and answered the how will i earn my 2/20 in 07 question with the "put on a nice little carry trade" and then as the trade performed well, well, it got harder to sit on the sidelines/ take the other side. anyone out there short brazilian real local rates? outright short -- not hedging v CDS? My guess is no. it costs too much.
Reply to this comment By bsetser on 2007-02-05 15:29:29
"...Net six-month fund flows into the yen, the lowest-yielding currency of the 19 in its basket, are at their most negative since March 2000. They have only been more negative for 5 per cent of the time since State Street started tracking them in 1995. Similarly, net flows into the Swiss franc, the 17th lowest-yielding currency, have only been more negative for 4 per cent of the time since tracking began. By contrast, net fund flows into the Brazilian real, the highest yielding currency, have only been more positive 6 per cent of the time..."
Reply to this comment By Guest on 2007-02-05 17:23:14
actually short real brazil bonds is strongly positive carry for a leveraged investor. ntn-b's yield 7.80 or so + sub 4% inflation funded at 13%. i think the long inflation linked trade in brazil is popular for its compelling fundamentals despite carry.
Reply to this comment By pb on 2007-02-06 10:32:37
pb -- i fear that I wasn't clear, i wasn't thinking "real" as in inflation indexed but "real" as in denominated in Brazilian real. and, judging from the price action and the brazilian reserve growth, there aren't many who are short brazilian real denominated assets.
Reply to this comment By bsetser on 2007-02-06 14:34:59
Brad, Either way, carry in brl debt (real ot nominal) is negative due to the inverted curve, with the nominal debt less so than inflation linked, and shorting is a positive carry trade when funded locally. If funded in usd, it is positive carry, but less so than just a simple currency trade. In other words, you decrease your carry while taking on more volatility/duration/credit risk, etc. I would agree that carry is the story in brl ndf and the currency futures on the BM&F, while the bonds are a different story (structural change in inflation, expected rate cuts, improving credit) in which leveraged investors are willing to pay away carry to go long.
Reply to this comment By pb on 2007-02-06 14:49:42
Guest, Gamma - Looks like I'm not doing a very good job of explaining what I mean... Sorry about that! Let me try and go about it from a slightly different angle. Imagine you are a bank dealer who has various corporate and institutional customers. Let's say Customer A (who could be a hedge fund, but not necessarily) comes to you and asks you to quote US$/JPY outright forward for 3 months. You offer him a quote. Based on that, he sells you JPY and buys US$ (say, US$ 100 mn) for settlement in 3 months. What does this mean? This means that you are now long JPY / short USD on a 3-month horizon. This essentially has 2 risks for you: spot rate risk and term structure risk (or, in other words, risk related to changes in the interest rate differential). Of these two, the spot rate risk is by far the largest and most volatile. So, unless you want to take an active proprietary position of being long JPY / short USD 100 mn on a 3-months horizon, you need to hedge this position. Thus, the first thing you do is you sell JPY / buy USD 100 mn in the spot market. Now you have only one problem remaining: duration mismatch. And there are two possible ways to solve this. Option 1 - Theoretical: actual borrowing and lending Having sold JPY and bought 100 mn USD in the spot market, you can borrow yen which you'll deliver and settle on T+2, while taking physical delivery of the US$ 100 mn. This gives you the dollars you'll need to deliver based on your outright forward obligation in 3 months' time. But for now you place these US$ 100 mn on deposit. In 3 months' time, you get the US$ + US$ interest, deliver against the yen, and repay the yen loan + JPY interest. While you could do this in theory, nobody ever does this in practice - too impractical, too much of a hassle, but most importantly - every act of borrowing and lending expands your bank's balance sheet, with obvious consequences for regulatory capital, etc. Instead, banks do the following: Option 2 - Practical: hedging in the spot + FX swap markets Go back to the point when you just ended up with the risk on your book of long JPY / short USD 100 mn on a 3-month horizon. Again, you hedge it first in the spot market - buy USD 100 mn vs JPY. Then, you do an FX swap transaction. Remember, an FX swap has two legs: buy currency A and sell currency B spot, and AT THE SAME TIME sell currency A and buy currency B for future delivery, say, 3 months forward. If you do this, the first leg of the swap CANCELS OUT the spot transaction you just did previously to hedge your spot risk (i.e. buy USD 100 mn and sell JPY, then sell USD 100 mn and buy JPY at the SAME spot rate), so no physical cash flows are triggered on T+2. All you are left with is a 3-month obligation from your original transaction with Customer A to deliver US$ 100 mn and receive yen AND your new obligation to receive US$ 100 mn and deliver yen in 3-months' time from the second leg of your FX swap hedge. You are now fully hedged! Notice how your transaction in the spot market and the first leg of your FX swap transaction CANCEL EACH OTHER OUT, leaving just an outright forward, which hedges your original obligation to customer A. It is EXACTLY the same concept as in my previous carry trade example of Spot Trade + FX Swap Trade, where step 1 and step 2 cancel each other out, leaving only step 3 - the outright forward. The only difference is that in my earlier example you're not doing it to hedge your risk, but to take risk in the most efficient and cheapest way possible. Hope this helps explain it a little better. Regards, Andrew
Reply to this comment By Andrew Rozanov on 2007-02-06 18:42:07
Thanks Andrew for explaining that again.
Reply to this comment By Gamma on 2007-02-07 14:11:53
Thanks Andrew. What confused me was why making an explicit FX step with outright forward (if you can get an outright forwad with favourable rate). The way you describe it (FX spot + FX swap) now is what I thought of when looking at the article originally.
Reply to this comment By enderv (was:Guest) on 2007-02-08 01:35:28
I have been discussing the yen carry trade in my work for some long time and I have enjoyed this discussion.The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested. In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion. However, as has been noted here, it is not necessarily the case that carry trades will show up in these statistics. Carry trade transactions could be on the other side, for instance, of hedging by Japanese exporters in the forward currency market, which would not show up in bank balance sheet statistics. The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this. There are a number of connected reasons for believing this, which I will try to summarise briefly; 1) The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause. 2) Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness. 3) Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring). 4) The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view. 5)There seems to be a relationship between the yen and the enormous credit bubble which now completely dominates global financial markets and the economy. In my work I had a chart (mainly for fun) showing the very close relationship between Goldman Sachs share price in dollars and the S&P 500 in terms of yen. There are plenty of other similar relationships I think you could show. When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that. Tim Lee
Reply to this comment By Tim Lee on 2007-02-08 10:42:17
Can one actually capture the spread yen/dollar: ~5% leverage 2.7x = 13.5%/yr and have your original principle 100% safe?
Reply to this comment By Guest on 2007-06-08 17:36:56

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