Friday, February 2, 2007

How Big Is The Yen Carry Trade?

Attention has recently been focused once again on the yen carry trade and its effects on global liquidity and asset inflation. The EU is concerned and wants to step on the brakes, while the US does not. One can only surmise that US investment banks and funds are making a bundle from it.

First a definition: the yen carry trade consists of borrowing yen at near zero interest rates (the Bank of Japan equivalent of the Fed funds rate is at 0.25%) and immediately selling the yen for another currency to invest at higher rates. The low-cost yen loan is "carrying" the high yield investment.

For example, one such trade would be to borrow yen at 0.25%, sell them for dollars in the spot FX market and deposit the dollars at a bank for 5.25%. If the dollar/yen exchange rate does not change at all there will be a net gain of 5.00% in one year - this is called "the carry". In practice, the gains could be much greater because such trades are frequently done on margin and could result in 5 or even 10 times leverage - the gains would be 25% or 50%. Naturally, the high leverage would also mean very high losses if the trade goes against the speculator.

There are three risks: (a) that yen rates go higher, increasing the borrowing cost, (b) that dollar rates go down, decreasing the return and (c) that the yen exchange rate strengthens against the dollar requiring more dollars to repay the yen loan. Nothing prevents any two of the above, or even all three, from occurring at the same time. That would be very damaging to the speculator, of course.

But how much money is out there pursuing such yen carry trades? No one knows for sure, but I think it is somewhere between $1 to $2 trillion and I will explain why.

The easiest, one-step process to put on a carry trade is to do a foreign exchange forward swap. It consists of selling yen for dollars at today's spot exchange rate and agreeing to buy them back on a pre-determined forward date and at a pre-determined exchange rate. I will spare you the math and tell you right away that the difference in the two exchange rates (forward minus spot) translates to the difference between the two interest rates. Such trades are extremely common between banks and other financial institutions and can be put on for anything from one day to one year.

Once again we turn to our trusty Bank of International Sttlements (BIS) for data. As of the end of June 2006 there were the equivalent of $3.8 trillion in such yen forward swaps vs. $2.3 trillion just five years earlier. For a country with near zero economic growth and zero interest rates for a decade, a 65% jump in FX swaps can only point to very widespread speculation.

Source: BIS

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