Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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