Carry on Trading

By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks, Thursday, 6 September 2007, 7.45 am and 7.20 pm)

The power of belief can never surprise us enough. If we believe in a powerful force above us, our actions tend to be bolder. And we believe that we’ll be protected from harm.

That’s probably what the 23 Korean Christian workers thought when they set out for Afghanistan recently. Despite the obvious danger, they directed their bus ride into hostile territory.

In the world of finance, belief is very important. It is our belief in the authority of the central bank that keeps things running smoothly. Recently, belief in the power of the Bank of Japan, or BoJ, might have prevented the global markets from a worse meltdown.

This happened in the “yen carry trade”. First, let’s remind ourselves what this is. It is the borrowing and selling of currencies with low interest rates, and the buying of currencies with high interest rates. The idea is to profit from the gap in the two interest rates.

For example, an investor borrows 1,000 yen from a Japanese bank, and then converts the money into US dollars and buys a US bond. Let’s say the bond pays 4.5% and the Japanese interest rate is 0.5%. The investor stands to make a profit of 4.0% as long as the yen-US dollar exchange rate remains the same.

The profit can be bigger when there’s leverage, or when the investor borrows money for his bet. If the investor uses a leverage factor of 10, or he borrows ten times his capital, he stands to make a profit of 40% from his original capital.

The risk here is in the uncertainty of exchange rates. If the US dollar were to fall 4% against the yen, the investor would lose all his 40% profit. To prevent this, the investor must unwind his carry trade by selling his US bond, convert his dollar into yen, before the dollar falls 4%.

For many years, it was feared that the next time the global markets fall, the unwinding of the estimated US$160 bn in the yen carry trade would worsen the meltdown.

But this didn’t happen last month. It was not because of the intervention of BoJ. Rather, it was because of the intervention of a new breed of forex players. These are the Japanese uncles and aunties.

For a long time, these uncles and aunties had been just conservative bank depositors. But in the past two years, they have moved into high-risk, high-return margin trading of currencies. They are now big players, taking about 30% of all yen trades.

During the recent meltdown, when foreign carry traders were unwinding and buying the yen, these Japanese uncles and aunties took it as the chance to sell yen and jump onto the yen carry trade.

They did it because they believed that BoJ would continue with its weak yen and low interest rate policies. And they also believed that BoJ had the power to intervene successfully if it wanted to. This belief arose from BoJ’s huge success in punishing yen speculators in year 2004.

Because of the belief of our Japanese uncles and aunties, the yen is only slightly stronger today, by about 7%. This may have played a big role in cushioning the recent market meltdown. Compare this to the 1998 Asian currency crisis, when the yen strengthened some 30%. That killed many yen carry traders.

While the belief of the Korean Christians took them on a rough ride, the belief of our Japanese uncles and aunties may have saved global markets from a rougher ride.