The
scenario of an appreciating dollar and the large interest
rate differential between Japan and the US gave rise
to profitable trading opportunity. Japan raising its
interest rate and abandoning its zero-rates policy is
bound to make "Yen Carry Trade" unviable resulting
in unwinding of speculative derivative products.
Japanese
economy is growing. Consumer spending, which accounts
for more than half of $4.57 tn Japanese economy, grew
at twice the pace during the first quarter of 2006 as
the unemployment rate is at its lowest in almost eight
years. Japan's growth rate was an annualized 5.5% in
the fourth quarter of 2005, which indicates that the
country is finally coming to the end of seven years
of deflation. Corporate investment also exceeded forecasts
as companies are going for fresh investments and capacity
expansion. This growth has also prompted Bank of Japan
(BoJ) to abandon its Zero Interest Rate Policy and raise
its benchmark interest rate from virtually zero (0.069%)
to 0.25% in July 2006. This strong show of economy and
rise in interest rate has made at least one class of
people unhappy—the practitioners of `Yen Carry
Trade'.
Yen
carry trade, to put in simple words, means borrowing
funds in yen at a very low or negligible interest rate
and using the loan to invest in higher yielding assets
in other markets.
Let
us assume that an investor borrows 100,000 yen from
Japanese banks at virtually zero percent. He then converts
these yen into US dollars and invests these funds in
a US Treasury bond with a yield of, say, 5%. The profit
for the investor, thus, would be 5% as long as the exchange
rate between US dollar and Japanese yen does not change
and also the lending rates of the Japanese bank remain
unchanged. Many professional traders use this trade
because the gains can become very large when leverage
is taken into consideration. Now, if the investor in
our example has $100 mn in capital and can borrow $1
bn in yen, i.e., leverage factor of 10:1, which is quite
common and make 5% on that money, he actually has 50%
return on capital. |
