In 2001, however, the economy slid back into recession because of domestic problems as well as international factors
In the 1st quarter of 2008, Japanese exports grew by 19.5%
Current Statistics of Japanese Economy Key Facts: Services : 72% Industrial : 26.4% Agricultural : 1.4% Trading Partners US, China, South Korea, Taiwan and Hong Kong Economic Statistics ^As of March 2009 ^^As of April 2009 ^^^ May 2009
Introduction to Carry Trade In general terms the carry of an asset is the positive return received from holding it. For example, the interest received from a term-deposit account. The term 'carry trade' refers specifically to interest rates and currencies , between countries. Carry trade is the name of the strategy of going short in a low-interest rate currency and simultaneously long in a high-interest rate currency Each country sets its own interest rate, theoretically based upon the money supply and inflation.
Basics of Carry Trade Funding Currency Currency with low interest rates Target Currency Currency with high rate interest (high yield asset) Carry to risk Ratio It adjusts the interest rate differential by the risk of future exchange rate movements, where this risk is proxied by the expected volatility (implied by foreign exchange options) of the relevant currency pair.
Implementation of Carry Trade exchanging borrowed funds into the target currency in the spot market derivative contracts, including foreign exchange futures, forwards and interest rate swaps. Bonds Profit = I(f) – I (j) + E (1) – E (0) Participants: Hedge Funds, pension funds, charitable endowments, investment banks, and wealthy individuals
CARRY TRADE “Low Volatility” required. Exchange rate stability, reduces Risk appetite of investors “Interest Rate Arbitrage” differential Interest rate “Bad news is actually good news for Yen” More depreciation of Yen
Example Suppose a carry trader is looking for differential profit between GBP/JPY. One lot size (=100000) is bought of GBP/JPY Interest rates :GBP-5%, JPY-.25% Interest profit :$4750 approx ( USD/JPY =90) ( Buy/Sell 204.73/221.25)
Brief History In 1990-91 recession in US led to drop in interest rates. Search for yield led to Latin American and Asian investments.(Dollar carry trade) By mid 1990’s reversal happened in the US and also marked start of Yen carry trade.
What led to Yen Carry Trade? Excess Domestic reserves. (Mrs. Watanabe aka $15 trillion) External Asset /Liability structure of Japanese banks. Japan “Premium” Due to structural weakness of Japanese Banks BOJ easy monetary policy(ZIRP).
Signals towards Yen Carry trade DAILY TURNOVER(JPY)
Where does the money go? North America, OECD Countries, Offshore centers(OFC’s), and Emerging Asia total 90% of this money. “Round Tripping Operation” Moving money in different currencies and bringing it back to home Role of Caribbean OFC’s? Hedge Fund established in Cayman Island
Cumulative net flows via Banks :Q2 2002-Q1 2007
Hedge Fund Strategies Trade on a basket on currencies. Build a portfolio on currencies such that loss in one can be made up by others. Complex Neural network based Algorithmic programming to time the entry/exit of trades.
Pros & Cons of Carry Trade Potential “Bubble” creation East Asian crisis spillover effects to Brazil and Russia. Contagion effect. “George Soros” Unwinding Capital Flow Savings Rich Japan to High demand. Providesshorttermliquidity.
Unwinding Interest Rate difference between the two countries becomes minimal thus there exists no incentive to borrow Yen and invest overseas. Thus, Japanese Investors have started to sell their dollar and Euro investments and return their money to Japan. It impacts many currencies/markets as the carried yen is touring the globe. This means the Yen has been appreciating. Rise of Interest Rates in the funding currency
Because the Yen is rising, the Yen Carry trade becomes unprofitable, investors could lose substantial money if the Yen rises against the dollar and Euro. Therefore, with the Yen rising, people are selling their foreign investments and ending their carry trade. This increases demand for Yen even more, causing a further rise in the Yen. UNWINDING-------the avalanche
Effects of Unwinding Falling of Global Stock Markets Cascading Effect Selling of foreign currency to repay Yen loans Domestic Exports hampered Further rate cuts, with no scopes left Currency Crisis
Unwinding of Yen Carry Trade Sharp Appreciation of Yen October 1998 May 2006 February 2007
October 1998 LTCM debacle Long-Term Capital Management (LTCM) a U.S. Hedge Funds Trades were conducted through a partnership with Bear Stearns and client relations were handled by Merrill Lynch D/E = 25:1, off balance sheet derivative notional value of $1.25 trillion Russia declared it was devaluing its currency and basically defaulting on its bonds, In response, the U.S. stock market dropped 20%, while European markets fell 35%.
The short Yen carry positions - which had been used to leverage up LTCM's arbitrage activities - had to be paid back, and the USD/JPY fell (Yen strengthened) - initially very fast(9%), then by a more steeper(12%) drop. LTCM lost 50% of its capital value. Bankruptcy. Tiger Hedge fund lost $2 bn. Bankrupt.
February 2007 Harshly reminded carry trade is not purely based on interest rates but also on expectations. “Sub-prime mortgage” fears. Equity and commodities markets tumbled. Parallel retail buying gained strength. Caught BOJ off gaurd - led to Yen appreciation Margin Calls of leveraged accounts forced large scale unwinding Increase in Interest rate by BOJ to 0.5%
Dollar carry trade/Potential fears. Decrease of interest rates to near zero levels by FED. Dollar in international reserve asset / Depreciation would hurt economies. AUD/USD, NZD/USD, CHF/USD carry trade fears grew. Dollar unwinding could have massive “network” effects.