Gold, the Yen and subprime

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  1. AT says:

    Here is some more interesting commentary on the Yen Carry Trade by one of your valued partners…

    Blame the Yen Carry Trade – May 23, 2007
    By Stephen S. Poloz, Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada

    Is your currency rising unexpectedly? Blame the yen carry trade! Can’t figure out why copper prices are so volatile? Blame the yen carry trade! These days, the yen carry trade is being blamed for everything, and is popping up in everyday conversation.

    The yen carry trade can take on a variety of forms, but at the heart of each is a loan taken out in Japanese yen, the proceeds of which are used to invest in financial assets elsewhere in the world. It takes advantage of the fact that Japanese interest rates are extraordinarily low, while other countries’ interest rates are much higher. For example, an investor can borrow yen from a Japanese bank, convert the funds into Canadian dollars, buy a Canadian government bond, and earn an interest rate spread of around 4%.

    The best part of this investment strategy is that the investor makes a 4% spread return on the entire structure, most of which is not his money. He may be required to put up 5% or 10% collateral with the bank – essentially investing $5 of his own money to buy $100 in Canadian bonds, thereby earning a $4 return on just $5 invested, or effectively 80%. Layered on top of the structure is an expectation that the Japanese yen will continue to drift down while the Canadian dollar may continue to appreciate – another positive return.

    Notice that the more yen loans that are issued, and the more they are converted into other currencies, the more exchange rates move in a direction favourable to the underlying investors. In other words, exchange rate movements are almost inevitably exaggerated by the use of these complex financial wagers.

    How big a phenomenon is this? It is difficult to say but all indications are that it is very big. Data from the Bank for International Settlements in Basle, Switzerland (the central bankers’ bank) indicate that the use of these structures in foreign exchange derivative transactions has risen significantly in the past couple of years. Notional outstanding values are estimated at around $40 trillion. That should be compared to average global daily turnover in the foreign exchange market of about $3 trillion, which truly is colossal. But global GDP is only about $40 trillion.

    The problem with these structures is the potential for an abrupt unwinding of positions. An investor who decides to take his $5 out of the market sells $100 in Canadian bonds, sells $100 of Canadian dollars, and buys yen to close his position. Accordingly, a shift in expectations about monetary policies or currencies can lead to a very rapid evaporation of positions and huge moves in exchange rates.

    The bottom line? The yen carry trade is a legitimate tool for many financial institutions. But, like many synthetic financial structures, its over-use as a wagering tool runs big risks, both for the investors and for the global financial system at large.

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    The views expressed here are those of the author, and not necessarily of Export Development Canada.

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