I Have Got A Yen For You

Guest Author: My name is Mazy Hedayat, a lawyer in Chicago. I work with entrepreneurs and business people including software, Internet, and financial professionals. Futures and options are big in Chicago so it ought to come as no surprise that this post is from one of my clients who is a futures trader. Let’s call him Frank. Frank began buying stocks with money from his paper route in the early 70’s and parlayed that into a house and lifestyle within a decade. In 1982 he started trading the newly minted S&P 500 contract and hasn’t looked back. Nowadays he trades commodity-based futures in addition to stock index contracts like the S&P 500, NASDAQ, and Dow. He also trades the Yen …

Yen Carry Trade
The term carry trade refers to the practice of borrowing money in low interest markets like Japan, converting those funds into U.S. dollars, and buying financial assets in America such as treasury bonds, notes, DLLs and, for more aggressive types, hedge funds that invest in stocks or commodities.

Currently investors get a risk-free return of 3.75% on government bonds, which means they can borrow at 1/2% all day from Japan and profit risk free from the difference. This works out great unless there is a change in the exchange rate. Since the initial loan must be paid back at some point and Dollars converted to Yen, if the Yen rises against the Dollar the result cuts into profits. Since traders operate on razor thin margins using large sums of OPM (other people’s money, they can easily be put into the red.

Who Plays It
This is a game for Institutions, Hedge Funds and speculators with deep pockets. To appreciate the size of the playing field, consider that Japan’s monetary base is almost equal to that of the U.S., but it’s economy is about half the size. That means there is a lot of Yen floating around; far more than needed for domestic use. That makes it hot money. That hot money finds a home in countries that yield high rates of interest.

Hot Money Markets
With all that hot money looking around the world for a home, some of it was bound to wash up on US shores, and in fact over the past 3 years carry trade in the Yen buoyed the real estate market beyond where it should have been. When and that effect peaked in 2005 the hot money found a home in global equities and since equities have historically averaged a return of 8% per annum, many traders wanted to push the envelope. As a result they invested in emerging markets and started buying the debts of those countries, narrowing the spread between the rate for emerging country debt and higher quality debt such that from the US or Europe. In the end, with everyone using the same playbook we all ended up chasing a decreasing return.

The Yen Hits the Fan
On February 27, 2007 the Yen rose sharply against the USD. The result was a bloodbath that happened in stages. First, at approximately 1 AM CST Europe’s stock market was opening. Asia’s 800 lb. gorilla (China) had already shed 9% of its value by then. The German market opened sharply lower as well, down 7% by then. Since American stock index futures traded nearly around the clock, the Dow futures were already down 100 points by 5 AM. Clearly there was a global rout underway, and the rising Yen and falling stock markets were putting pressure on the Yen carry trade. Traders had to raise cash fast to settle their contracts, and the victims were to be the stock markets. By the end of the day the Dow was down 400+. While that only amounted to a tiny 4% move, it looked like the media thought the world was coming to an end.

As it turns out, reports of the world’s demise were greatly exaggerated …