Wealth Building Lessons

Professional investors have the opportunity to borrow money in japanese yen at interest rates of less than 1% per year. So they borrow hundreds of billions of dollars worth of yen and invest any stock, bond, commodity or derivative that looks like it can produce a higher than 1% yield. (When US treasuries are returning over 4%, that doesn’t seem too difficult). This is whats called the carry trade.

This might seem a bit complicated, but its really quite simple. Investors and some Funds have been employing this with great success and everyone looks like a genius. But this strategy is not without risk. A problem arises when the yen starts to appreciate more than the underlying yield of the investment. Then your leverage can wipe you out. Lets look at an example by Eric Fry.

Let’s imagine, for example, that an investor with $1 million wants to leverage that sum into $4 million. So he borrows $3 million worth of yen at 1% per year. (For perspective, one-year Japanese government bonds yield a miserly .64%, while 5-years yield 1.17% and 10-years yield 1.63%). Let’s then imagine that he uses his $4 million to buy T-bills yielding 5%. A 5% yield on $4 million produces $200,000 of interest. After subtracting the $30,000 of interest paid (i.e., 1% on $3 million), the investor would have received a net $170,000, or a 17% return on his $1 million of actual capital. That’s not too bad for T-bills.

But there’s a wrinkle. The yen’s value is not set in stone. In fact, it’s not set in anything other than the whims of the financial markets. If the dollar’s value against the yen were to fall even 4% during the course of a year, our hypothetical CD-buyer would begin to lose money. A 5% drop would produce a $30,000 LOSS…and some concern. A 6% drop ould produce a $70,000 loss…and mild panic.

And let’s remember that the real-world pain that our hypothetical speculator might endure could be much more excruciating than our example suggests. A 6% drop would produce an immediate $240,000 (24%) hit to his capital, while the $170,000 he hopes to pocket on this trade would merely trickle in bit-by-bit each month. So if our speculator were to suffer a sudden hit to his capital, he might not be inclined to continue risking it for the sake of recouping $170,000 over the ensuing 12 months. That’s why a 10% drop in the dollar/yen exchange rate could produce a run for the exits…from a wide variety of carry trades.

While you may not think a 5% drop might happen that often, it actually happened last week. That wave of panic may have spread across global markets. Luckily it pulled back and everything looks rosy again!

But if the Carry Trade does in fact begin to unwind, it might take down global markets as everyone tries to dump their holdings at the same time. Now is probably not a good time to be over-leveraged in low quality investments.

If you’d like to take advantage of the rising yen, the easiest way to do this is buying the Japanese Currency ETF - FXY. But please don’t buy it on my recommendation. Who knows how long the Yen might stay undervalued.

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