Yen carry trade mechanics

The discussion and subsequent blog post on Brad Setzer’s blog about the yen carry trade shows how difficult it seems to be even for those economists specializing in international economics to understand the mechanics of the currency markets. Andrew Rozanov commented on Setzer’s blog that the actual mechanics of the trade is as follows:

Step 1. Buy US$ / Sell JPY in the spot market (say, at 120)
Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120)
Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50)
Step 4. Buy UST in the spot market
Step 5. Borrow US$ against UST in the repo market

Most international finance people would regard this as a simple, matter-of-fact description of the mechanics except that they would club steps 2 and 3 together into “Swap spot dollars(yen) for dollars (yen) three months forward” (Romanov does mention this at a later stage). Most of the economists involved in this discussion however have difficulty understanding why the mechanics are as convoluted as this.

In any international finance course, this is among the first things that we teach – in the inter bank market, the way to do a forward transaction is to combine a spot transaction with a swap. Corporate finance people who deal with their banks and not directly in the inter bank market do not of course realize this because the bank synthesizes the forward contract for them out of these two components.

International economists think at an even higher level of synthesis – they collapse steps 2, 3 and 5 into a very simple step: “ borrow yen ”. The difficulty with that synthesis is that the cheapest way to borrow against UST collateral is the repo market in the US and not in the yen market. Moreover, since derivative markets are off balance sheet transactions, we would not see the carry trade at all until we break the transactions up into their pieces and start looking at the right places for evidence of the trades.

Posted at 7:57 pm IST on Mon, 5 Feb 2007         permanent link

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