The hysterical nonsense published and broadcast about the Japanese yen “carry trade” created an interesting opportunity for the cool-headed investor or speculator during the past couple of weeks.

There is such a thing as the carry trade, but it is not as large as it has been made out to be by talking heads, nor is it the cause of the present unease in financial markets. To gain some perspective, consider this: the Japanese ministry of finance and the Bank of Japan believe that short-term carry trade-related borrowings in the yen are equivalent to between $20bn and $40bn. When you add in the individual Japanese investors, the
“real money” buyers of foreign currency-denominated securities, the total is, they believe on the close order of $170bn.

As the readers of these pages will know, the carry trade is the financing of a high-yielding asset, such as a US mortgage-backed security or an Australian dollar bond, with money borrowed in a low-yield currency, such as the Japanese yen or the
Swiss franc. As long as the low yield currency does not increase much in relative value or see a rise in interest rate levels, the carry trader can capture a wide spread between the cost of borrowed money and the income from the financed asset.

Let us skip from primary to graduate school. How do you measure the risks of your short position in the borrowed currency? One way is to look at the long-term relative competitiveness of the country issuing the borrowed currency compared with the country
of the invested currency. Logical, but it can take a long time for your logic to work. Assuming you are right about this fundamental judgment, though, you could still be wrong
about how the market will price the relative values in the short run.

In the shorter term, the foreign exchange tribe measures how out of line a currency is through “risk reversal skews”. A risk reversal is an options strategy consisting of the simultaneous purchase of out-of-the- money calls (or puts) with the sale of out-of-the-money puts (or calls), at the same expiration date, and with similar deltas (roughly speaking, distance from positive monetary value).

Options pricing models, starting with Black-Scholes and going through all the variations on their work, will tell you that each side of this position should be about equally valuable. In this model world, a currency should, in other words, have about the same chance of rising or falling over a one-month period.

Of course, the forex traders know that the risk reversals are not going to have symmetrical values, but they use the model as a way of measuring just how asymmetrical they are – in other words, how supply and demand are affecting pricing. (They have adopted the convention of one month option expiry and a 25 delta, just to make sure everyone is using the same assumptions in discussions.)

What is the risk reversal skew in the Japanese yen telling us now? Well, as of last week, the skew was showing that people who had been listening to financial television commentators and reading weekly business magazines had been frantically buying call options on yen. Since, apparently, the end of the world was coming and the Japanese were about to stop lending yen, corporate treasurers and speculators had to get them at any price. The implied volatility of calls, which at the beginning of January had been about half a volatility point higher than puts, gapped out to about
1.7 volatility points by the beginning of March.

“That is the widest since March of 2004,” says Robert Sinche, a forex strategist with Bank of America. “If this had just been about the yen, the [market reaction] would have been more contained, but there was this perception that the yen carry trade was responsible for everything, including world hunger.”

This sort of over-reaction is more common towards the end of a market move, rather than at the beginning. Japanese officialdom, personified by Hiroshi Watanabe, the vice-minister of finance for international affairs, only weighed in with a warning about the carry trade towards the end of the mini-unwind, when he would have known the risks were already being discounted.

In fact, the yen is likely to weaken a bit from here, particularly against the euro. That is not a problem for the Japanese government, since the government budget benefits from the profits the Bank of Japan makes on its gigantic foreign exchange portfolio. It allows the Japanese government to reduce the budget deficit without tax increases before an election – always a good thing.

If there really were a collapse in the value of the dollar against the yen, which the hysterics on the television and on the forex customer lists were anticipating, then the ministry of finance would direct the Bank of Japan to buy dollars. They knew it was not necessary, since they could read the message of the risk reversal skews.

The market “correction” began because people realised that the adjusted numbers published on the US economy were not accurately recording the weakening of growth. All the talk of a carry trade unwind did, however, was to create an opportunity to buy some cheap yen puts against expensive yen calls.

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