Before examining the latest Japanese MoF and US Treasury intervention tactics, itââ¬â¢s important to understand how the ââ¬Åyen carryââ¬Â trade works. Itââ¬â¢s simple to understand, and itââ¬â¢s not just hedge funds and international bankers who engage in the trade. Many brokerage firms offer margin loans at near 1% in Japanese yen, which are re-invested by their clients to buy stocks around the world.
The ââ¬Åyen carryââ¬Â trade is primarily a simple game of interest rate arbitrage. Step 1: Borrow yen at 0.5% and convert the yen into $9,000 US dollars. Step 2: With $9,000 from Japan and $1,000 of your own money, invest $10,000 in US Treasury notes at 5.00%. Step 3: Collect $500 in interest from the US Treasury, and pay $45 to the Japanese lender. Step 4: Pocket the $455 difference as a profit, for a rate of return of 45.5% on your original $1,000. Step 5: Sell the US Treasury note, and convert the US dollars back into Japanese yen to pay off your loan.
Step 5 is the tricky part, because if the yen were to suddenly surge by 5% against the US dollar, the principal amount of the yen loan would also climb 5% from $9,000 to $9,450, which would wipe out the $455 profit from the interest rate spread. It would be nice to buy yen futures as a hedge against a climbing currency. The problem is that yen futures trade at a hefty premium to the cash market price.
Locking into a yen futures contract at say a 4.5% premium to the cash price would wipe out the profit from the interest rate differential between the two currencies. So carry traders must take on currency risk to play the game, which can go very wrong, if the yen suddenly shoots higher. And thatââ¬â¢s what happened earlier this month, when the Japanese yen suddenly surged by 5% against the Euro and US dollar, until US Treasury chief Paulson huddled with Tokyo financial warlords on March 6th.
On February 10th, G-7 central bankers had warned traders against the practice of borrowing vast amounts in low-yield currencies such as the yen and Swiss franc to reinvest for a profit elsewhere. ââ¬ÅWe want the markets to be aware of the risks of one-way bets, in particular on the foreign exchange market. One-way bets in the present circumstances would not be appropriate. We want the markets to be aware of the risks they contain,ââ¬Â said European Central Bank chief Jean ââ¬ÅTrickyââ¬Â Trichet.
Japanese Finance Minister Koji Omi was singing from the same song book. ââ¬ÅThis means that G-7 countries think that markets, particularly foreign exchange markets, should recognize the risk of moving in one direction too heavily. I think we have come to the appropriate conclusion,ââ¬Â he said. And when the chief of the powerful Japanese ministry of finance speaks, currency traders listen but donââ¬â¢t always obey.
