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To: Aaron Cooperband who wrote (72461)	10/16/1998 8:51:00 AM
From: nihil	Read Replies (1) \| Respond to of 176387

RE: Profit by covered interest arbitrage Aaron. We've discussed it before. True, the unhedged trade as sought in the article I was commenting on is usually more profitable, but unfortunately, every once and a while it goes against you, the yen rises and you are ruined, which is what happened to the big boys this week. We are lucky no one lent us mere mortals yen. The covered trade is something else. Consider the situation on Oct 2, when the dollar was 134.21 spot yen, Dec yen closed at .7447 on CME, and if one could borrow Y134,210,000 for three months at 0.5 per cent he would owe ~Y170,000 interest in December. He could take his $1,000,000 that he got from selling spot proceeds for dollars, and then earn 5% in CD's or bills or $12,500 for the dollar investment. To hedge his yen exposure he would need to buy about 11 dec yen futures contracts, and deposit a few thousand in T-bills as margin. Big swings are possible and he might need to add margin. Regardless of the movement of the yen futures, the hedge will allow him to repay the yen loan at maturity. And he should make approximately $12,500 - 1,250 = $11,250 (less commissions). Alternatively, to limit his yen exposure to .7450 he can also buy December .7450 calls for premium of $22,200. Covering with calls alone is too costly to consider. He could sell $1 million in december .7450 yen puts for $22,500. If the yen fell, he would be put 134,211,000 yen at the strike (using up the proceeds of his dollar loan maturity and margined by his bills or CDs). He would therefore make an extra $22,500, but would still have been exposed to his original risk of a rise in the yen. This option trade is mandatory since he is already short 134 M yen. He could use the proceeds to buy calls, and break even on his perfect hedge. The problem is not sharp-eyed FX traders in Tokyo but sleepy traders in Chicago -- because this possibility of riskless pure profit has been open for a long time it is interesting that position traders have allowed the yen to be overpriced so long. It is not surprising that the whole trade collapses over night and that unhedged carry traders get it in the shorts. It is clear that these traders were not currency arbitrageurs, but were risk arbitrageurs speculating against the yen. Please note that the covered yen-dollar interest arbitrage is only profitable off and on, but it is on surprisingly often and open to a lot of investors, Any futures broker will lend you future yen if you sell yen short (i.e. borrow yen) on the CME (and fractionally margin your shorts with T-bills.) You can hedge this exposure in the options market -- usually without much cost. You recognize that you must calculate carefully and have interest bearing capital to offset the yen sale -- say T-bill futures and move like lightening. Commissions are cheap and it is possible to increase your yield above T-bills with nothing but cometary risk. Obviously these trades are limited to your capital -- which is why it is so attractive to businesses and banks and others who keep large amounts of relatively sterile short term funds. In perfectly hedged deals you will be able to gain substantial leverage in the futures market -- like 20:1. Thus if your covered arbitrage earns even 1 per cent over T-bills, you are talking a 20 per cent return on the trade. And the leverage is not dangerous. Of course, some day some clearing corporation may go belly up. Another good argument against diversification.