<< I've known about Yen carry for more than a year now. But I've never figured out how I can pull it off>
(Sorry, but my response here is far too long.)
You don't have to do the actual mechanics of the trade yourself (borrow yen, convert to USD, invest in Tbills, at maturity convert USD to yen, pay off yen loan). Due to the possibility of arbitrage between such a trade, and a yen futures contract, the pricing of different month yen futures contracts follows the economics of the carry trade quite closely (because if the yen futures contracts were significantly mispriced relative to the yen carry trade, it would open up "risk-free" arbitrage opportunities for pros to exploit).
To mimic the Yen carry trade, you short a yen futures contract, and hold it for a period of time (equal to the period of time for the carry trade you are trying to mimic), then close out (buy/cover) the futures contract. Your profit or loss on this operation will be almost exactly the same as a yen carry trade of the same notional value as the face value of the futures contract.
Say you were to short one Dec 98 CME Yen (symbol: JY98Z - JY = Japanese Yen, 98 = 1998, Z = month code for December). It settled today at .007536, meaning that the value of delivering or receiving Yen in Dec98 is today worth .7536 cents (US) per yen. The size of the CME Yen contract is 12.5 million yen - multiplying the contract size by the price per unit gives a notional value of this contract at 94,200 USD.
Note though that the settlement price for the Sep 98 CME Yen (symbol: JY8U - U = month code for September) was .007441, which is a different value from the December 98 contract. The September contract is for the same amount (12.5 million yen), the only thing that is different is the price, and the fact that it settles three months earlier than the December contract.
( To see realtime quotes for regular and after-hours trade, go to:
quote.com
and use the symbols "JY8Z" and "JY8U")
Now note that the ratio of the December to September contract is 7536/7411 = 1.0127, i.e., the December contract is worth 1.27% more than the September one. And 4 * 1.27 (there are four 3 month periods per year) means that this is 5.10% on an annualized basis.
Voila! 5.1% is awfully darn close to the difference between U.S. and Japanese short term interest rates (say, US Fed Funds 5.5% minus the Japanese Discount Rate 0.5%).
OK, so how do we "earn" this "carry trade interest"? If you were to have shorted the December contract today, and hold it for three months, during which time the USD-yen exchange rate did not change, you would find that 90 days from now the quoted market price for a Dec 98 Yen contract would be awfully close to .007411 (i.e., today's value of a Sep. Yen). Closing out the December 98 Yen at that point would net you a cash profit of 0.007536 (your sale price) minus 0.007441 (your purchase or covering price), times 12.5 million, which is $1187.50. Note that $1187.50/$94,200 (profit divided by notional value) is 1.26% of the notional value - the amount of interest you earned in a quarter of a year.
Now what would be the costs of this trade?
As you note, you have to put up margin in your futures account. The margin for a CME Yen contract is about $3,000 right now, meaning that $3,000 can control $94,200 worth of futures. That is 30x leverage (!). The quickest way to lose your margin (and perhaps more) is to attempt this trade with minimum margin. Keep in mind that the economic equivalent of what you are doing is borrowing nearly $100K worth of a foreign currency, being fully exposed to foreign exchange gains or losses on this amount of money. While it may be prudent to use *some* leverage in order to control more money than your available capital, keep in mind that you will be permitted to use far more leverage than you probably should.
A much more prudent amount of margin would be, say $10,000. This is 9.4 times leverage, which is still a helluva lot of leverage (you are planning on earning $1187 in three months on this money - you better believe that this is a lot of leverage, and not totally without risk!).
Anyhow, the margin you place with your broker may be in the form of Tbills. So however much margin you put up (and more is better), you will earn 4.5% per annum (or whatever the current Tbill rate is), on this margin money. Your margin deposit, however large, thus earns interest.
So what you will earn, after three months, is the $1187 on the carry trade (futures trading profit), plus whatever interest your margin Tbill earns for you.
From this you must deduct the cost of commissions, which will vary from $30 to $100 for a "round turn" (1 buy and one sell), which is what we have here.
Now the exciting part. The reality is that the value of the yen does in fact fluctuate from day to day. On a daily basis, a futures account's daily profits or losses are settled in _cash_. As the trade moves in your favor, real cash accumulates in your account, on a daily basis - you can, if you want, withdraw this cash, invest it, or whatever.
The flip side of this is that any losses you suffer must be paid, in cash, daily. So called "paper losses" and "paper profits" in futures trading are anything but - they are settled up daily, in cash.
Since even a profitable trade will likely spend some portion of its lifetime in a debit position, it is necessary to be prepared to supply whatever amount of daily cash infusions are required.
Just like the yen carry trade, you will fully participate in currency gains or losses, based on the USD-JPY exchange rate. If the yen weakens from its present level of 134 per dollar (134 = 1/0.007441) to a weaker level of 142 per dollar (1/142 = 0.007042), your account will gain .007441 - .007042 = .000399 * 12.5 million = $4987.5 cash. So your account would contain one Tbill for $10,000 plus $4987.5 cash. Ain't this futures stuff great?
The other side of this, of course, is if the yen were to strengthen to 126 yen per dollar (1/126 = .007936). In this case you would be required to pay .007936 - .007441 = .00495 * 12.5 million = $6187.5 cash. Your account would contain one $10,000 Tbill, and the $6187.50 that you would have been required to deposit will be gone (to whoever happens to hold the other side of the contract). So the Yen weakening from 134 per dollar to 126 per dollar just lost you a whole bunch of money!
Keep in mind that it can get better than this, and it can get worse than this. Profits take care of themselves, consider your loss if the yen were to strengthen to 112 yen per dollar (1/112 = 0.008928). The loss in this case would be $18,587.5.
The lesson here is that an $18,000 loss is probably easier to bear if you started out this speculation with a $10,000 Tbill and $5,000 of ready cash, than if you did the same thing with only $3000 margin (exchange minimums).
Before you decide that "futures trading is too risky", or even worse, neglect to properly consider the risks, realize that shorting one yen contract is essentially the economic equivalent of performing a $94,000 yen carry trade. If you desire and can afford a $94K yen carry trade, you can equally afford the to short one CME yen futures contract.
Likewise, do not let the "only $3000 down!" aspect of futures trading lull you into a trade, if you do not desire and it does not make economic sense for you to place about $100K of borrowed money at foreign exchange risk. Because, good or bad, profit or loss, that is *exactly* what you are doing.
- Daniel
P.S. for more information on the CME (Chicago Mercantile Exchange) yen and other currency futures, see cme.com |
