Land of Rising Sun and Falling Yen

7 de nov. de 2022

CME: Micro USD/JPN Futures (CME_MINI:M6J1!)
On September 21st, the Fed raised interest rate for the fifth time. The very next day, Bank of Japan decided to keep the country’s short-term interest rate at -0.10%. On November 3rd, the Fed raised another 75 bps, and the Fed Funds rate is now 3.75-4.00%.

Interest rate spread between the two countries now reaches 4%. With Japan determining to stay accommodative, the rate spread could be over 500 basis points by early 2023.

This is show time for carry trade, a popular and time-honored forex strategy.

What is Carry Trade?
A currency carry trade is a strategy that involves borrowing from a low yielding currency to fund the purchase of a currency that provides higher interest income. This strategy attempts to capture the rate spread, which can be substantial with the use of leverage.

Carry trade is one of the most popular trading strategies in the forex market. In essence, it is as simple as "buy low, sell high”. Popular carry trades involve buying currency pairs such as AUD/JPY and NZD/JPY, since they have decent rate spreads over time.

Profit of carry trade largely comes from its ability to earn interest. Income is accrued every day for holding long carry positions. Below is a typical daily interest accrual formula:
Daily Interest = (IR(long) – IR(short)) * NV / 365

where:
IR = interest rate
NV= notional value

Another source of profit results from the exchange rate changes from the time a trade is initiated to the time it is closed, which could be illustrated by the following example.

DIY Guide for A Synthetic Carry Trade
Assumptions:
1. You have built up $100,000 in home equity from your $500,000 house
2. Foreign currencies can be bought and sold with your bank, without restrictions
3. Home equity loan costs 7.2% annually
4. Borrowing rate for Japanese Yen is 2.2%

Home equity loan rate rose sharply due to the Fed rate hikes. However, since your bank acquires cheap Yen from Japan, they could charge 2.2% and still make money. When you pledge your home as collateral, your yen loan is low risk from the bank’s perspective.

Trade Initiation:
• At USD/JPY rate of 115 (using rate at the end of last year), you borrow 11,500,000 yen from the bank for 1 year, and immediately exchange it into USD 100,000.
• You buy a 1-year Jumbo CD (certificate of deposit) from the bank, which yields 4.2% with a minimum purchase of $100,000.

Trade Closing:
• One year later, unwind the trade.
• Turn your CD in and get $104,200 from the bank.
• You exchange Dollar back to Yen at 150 (recent rate) and get 15,630,000. After paying back 11,500,000 in principal and 253,000 in interest, you net 3,877,000 yen.
• One-year return is 33.7%. Just 2% comes from rate spread (4.2%-2.2%). The rest derives from yen depreciation, which allows you to pay back the loan with fewer dollars.

In this example, we do not use leverage as home equity is in place to fully guarantee the loan. By borrowing with yen, we effectively lower the home equity loan rate from 7.2% to 2.2%. Instead of putting it in CD, you could find more productive use of this low-cost capital, such as paying down a 20% credit card debt.

Usually, interest rate spread is the main income source for carry trades with exchange rate gain as a bonus. With yen dropping to 32-year low, the latter becomes very prominent this year. Borrowing yen from the bank is equivalent to shorting the yen futures.

Hedging the Carry Trade
Most traders work with a forex broker to take on carry trades. Their trades are usually unhedged. Large leverage is used to amplify the returns from small interest rate spreads. In today’s volatile markets, naked carry trades could be very risky. Trades using 50- and 100-time leverage could easily blow up if exchange rate moves against you.

In my opinion, sizable USD/JPY interest rate spread could stay for a considerable period of time, at least throughout 2023. However, Yen may have already bottomed at 150. Bank of Japan has intervened the market by emergency bond buying.

It is a good time to do USD/JPY carry trades. However, it would be wise to protect your positions in the event of a yen rally. Yen lost some 25% against the dollar so far this year. If it rebounds just 5%, it could wipe out all the returns from interest rate spread.

CME Micro USD/JPY futures contract (CME_MINI:M6J1!) has a notional value of $10,000. At settlement price of 144.71 last Friday, each December contract is worth 1,447,100 yen. Initial margin is 45,000 yen per lot, or approximately $311.

If you expect yen to appreciate, consider shorting the futures. As it is quoted yen per dollar, rising yen will result in each dollar exchanging for fewer of it.

Happy trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/