Yen cf trade

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Official Power point presentation by Mr Neeraj Batra ,Chairman of infinity business school and one of India's leading investment bankers.The presentation explains the concept of yen carry forward trade.

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Yen cf trade

  1. 1. The Yen Carry Forward TradeNeeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  2. 2. o The Japanese market is Export driven. The Govt. The Yen Carry Forward Trade keeps the yen USD rate in a narrow band to avoid Unemployment and stimulate Domestic Spending. The Worlds Second Largest Economy has had a negative growth rate in the last three years and is expected to grow at 1.40 % in 2010/11o The Japanese have amongst the lowest interest rates in the world. Long term Govt. debt is already at 180 % of GDP and expected to exceed 204 % of GDP as The Japanese Govt Announced a USD 1 Tn Budget for 2011 which will cause Public Debt to rise by USD 485 Bn to roughly $10.50 Tno Thus the Japanese Govt. has a biased position to keep interest rates low- to fund its own debt, avoid deflation and spur investment/domestic demand.o On a positive side 90 % of this debt is held by domestic Japanese Investors and Japan’s Cumulative domestic savings exceed $ 15 Tn.o The Bank of Japan intervenes aggressively to keep the yen peak to protect its exporters.Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  3. 3. The Yen Carry Forward Trade• However the Japanese population is ageing. In the next 20 years, 33 % of its population will be over 65 years old. This may cause a problem for funding Govt. Debt in the future.• Japan has the second largest USD reserves of approximately USD 1.05 Trillion and enjoys a large current account surplus. Between 2001 and 2009 these reserves Grew from USD 350 Bn to 1 Tn.• However during this period the JY remained weak vs.the USD and moved from 104 to 120 (It currently trades at 91.50 after the unwinding of the Yen C/f Trade)• Between 2004-7 Global hedge funds exploited this situation They understood fully well that despite low interest rates the exchange rate will be managed by the Central bank of Japan and kept weak against the USD.Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  4. 4. The Yen Carry Forward Trade• This resulted in what is popularly now known as the Yen Carry Forward Rate• This assumed many forms. It resulted in cross currency exposure (between the JY and the relevant counter currency) and also a cross asset exposure• E.g. a Borrowing of JY and subsequent investment in a US Treasury Bill creates a USD/JY Exposure on maturity of the Loan/Investment.• Hedge Arbitraged and Borrowed in JY. Sold the JY to convert into USD. Then Invested the USD in Govt. bonds of New Zealand which yielded 8 %pa• More commonly hedge funds borrowed JY ,shorted it in spot markets to buy equitiesNeeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  5. 5. The Yen Carry Forward Trade• Logically if the interest rate on one currency is lower than the interest rate for another currency (for a similar maturity) then the first currency must necessarily trade at a premium (i.e. be more expensive in the forward market) to the second currency in the Foreign exchange markets such that there is no arbitrage possible between the currency and money markets e.g. if interest rates in JY are at 1 % pa and USD are at 3 % pa for One year then it follows that the one year forward JY/USD exchange rate must negate this 2% % interest difference entirely.Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  6. 6. • Lets test this hypothesis The Yen Carry Forward Trade • A currency with a low interest rate must quote against a currency with a higher interest rate at such a premium in the forward foreign exchange markets such that the interest differential is negated • Unless this happens arbitrage would be constantly possible (see example) Money Market Forex Market JPY 6 1.20% Spot Rate 85 Month Rate USD 6 3.60% 6 Month 83.998 WHY Month rate ?? RateNeeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  7. 7. • A Hedge Fund borrows 6 month JY 85 The Yen Carry Forward Trade Mn for 6 months @ 1.20 % pa • He then sells this JPY in the Spot Foreign Exchange Markets to get USD 1 Mn • He invests the USD 1 Mn at 3.60 % pa in the US Treasury Bill markets Now after 6 Months he owes the Japanese Bank: (85 Mn X 6/12 X .012 )+ (85 Mn) JY 85,510,000 • His Investment in the US treasury will yield as follows: 1 Mn x 6/12 x .036 + 1mn= USD 1,018,000Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  8. 8. • Thus unless the 6 month Futures Fx rate is The Yen Carry Forward Trade 83.998 arbitrageurs would make risk free returns i.e. the yen must quote at a premium (more expensive) to the USD to the exact extent of the interest rate differential or 83.998 in the 6 month futures market.• Anything weaker say 87 , Hedge Funds will do the following:• If JY/USD quotes 6 month fwd 87 then HFs would borrow JY at 1.20 % 87 mn (spot rate), sell yen to get USD 1 mn• Invest in 3.60 % T Bills and• Simultaneously the HF Would buy JPY 6 month forward at 87 for an equivalent USD of 1,018,000 (Why ?)Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  9. 9. • After 6 months the HF would owe the The Yen Carry Forward Trade Japanese Bank JPY 85,510,000 • It would receive USD 1,018,000 from the US market • It would have converted this USD Amount already at the 6 month Fwd contract and would get 88,566,000 JPY (87 x 1,018,000) • Thus the HF would make risk free 3,056,000 Mn JPY (88,566,000- 85,510,000) • Thus the Fwd 6 month Fx rate of yen must quote exactly at 83.998 i.e. the premium = Int.rate differential on the Spot day. • The real JY/USD Spot Rate after 6 months may however be higher or lowerNeeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  10. 10. • Anything stronger say 83 , Hedge Funds will The Yen Carry Forward Trade do the following:• HF will Borrow USD at 3.60 % 1mn (spot rate), sell USD to get Yen 85 mn. Thus he will owe the Bank 1,018,000 after 6 months• Invest in 1.20 % JY Deposit and simultaneously buy USD 6 month forward worth 85,510,000 JY (Why ?) at 83 worth 1,030,240• Thus he makes a profit of 12,240 USD per USD 1 Mn borrowed as an arbitrage profit without assuming any risk.• Thus only at the exact exchange rate of 83.998 does arbitrage get preventedNeeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL
  11. 11. The Yen Carry Forward Trade • However since the Japanese Govt. wanted to keep its exports competitive it did not like the Yen to appreciate • This resulted in HF taking a bet on the forward rate of the USD/Yen maintaining a narrow band such that the fund could take advantage of the interest rate differentials but keep an open forward position on the exchange rate till maturity and resulted in Trillions of Dollars of Yen Carry Forward Trade till 2008.Neeraj Batra GCMI Copyright INFINITY BUSINESSSCHOOL

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