Leverage is not for the faint hearted

Following the recent gyrations in the financial markets, one does worry about the degree of financial leverage some of these market players take to achieve better returns.One favorite play by such market players is the yen carry trade.What makes the yen carry trade so dangerous? Read on....

Highly leveraged yen carry trade makes the prospect of financial tsunami more real. Due to the thin spread between currencies, traders have to use leverage in order to realize profits to justify the enormous risks in currency trading. For example, a trader borrows 1000 yen from a bank and converts the funds into US dollars and buys a bond with that amount. Assuming that the bond pays 5.0% and the Japanese interest rate is set at 0.25%, the trader makes a profit of 475 bps. However, using leverage can reward the trader very handsomely. If he uses leverage with a factor of 10:1, he can stand make a profit of 47.5% provided if the exchange rate remains stable.

However, if the yen gains strength and gains from120 yen to 110 yen, the trader now makes a loss. His loss is now 8.3% (120-110/120).But in this case, he has used a leverage factor of 10, so his actually loss is 83%.Clearly this strategy is fatalistic if the Japanese Yen gains strength which can be worse if the investor has made investments into dubious financial instruments such as subprime CDOs, CDS.

In the financial markets, it’s often difficult to measure the size of such carry trades as they involve several currencies. Compounding the already bad situation is the use of swaps, derivatives and futures. Given the increasing diversity of the trades, even seasoned market watchers are unable to predict the next sudden unwinding of the yen carry trade.

The BOJ’s policy of keeping interest rates may cause “distortions” in asset allocations and flows of capital globally. Recently, the Bank of Japan decided to raise interest rate by 25 bps to 0.5 %.This created fears among government officials who felt any increase in interest rates may affect Japan’s slowly recovering economy which is estimated to grow at 2% this year. In Japan’s case, a weak economy needs to keep interests low in order to “stimulate enterprise and investment in economic growth”. Thus, any further increases would be "very gradual" according to the Bank of Japan, leading market players to continue borrowing yen to invest in higher yielding assets abroad. This will only further exacerbate the already worsening situation.

A recent study by Barclay capital raised a few eyebrows. In the study, Barclay stated that “"The magnitude of Japan-funded carry is reaching scary levels, in our opinion," and added that "even if the macro environment remains benign for carry trades, we cannot rule out the possibility of a sudden unwinding of positions that simply feeds on itself.". Even a small fluctuation in exchange rates would cause traders to unwind their positions as they would be unable to afford the losses due to the large amount of leverage that they have employed.

Types of investors

Japanese Insurance companies: Insurance companies make profits through 2 ways

1) Underwriting. Using actuarial science to help quantify risks and determine how much to charge for the insurance policy being underwritten.

2) Investing the premiums from the insurance policies. The insurance companies earn
returns by investing the “float” into a portfolio of equities and bonds

Given the zero interests rates environment, insurance companies were forced to invest abroad in higher yielding assets.

Japanese retirees: Due to the ageing population, more and more Japanese are living longer. However, these retirees need increased returns to meet their old age needs. Investing in the Japan would be difficult given the deflationary environment and low interest rates. Hence, these retirees are forced to invest abroad to seek better returns.

Speculators: The speculators borrow large amounts in yen and aim to use leverage to help generate large profits. Their investment horizon is normally short term and are quick to close money losing trades. This can have an adverse effect especially when the yen carry traders are rushing back to convert foreign currencies back to yen. This can cause the yen to gain in strength, causing further losses to traders who are still holding their position. A sudden influx of financial flow back to Japan can destabilize the foreign currencies and lead to sharp drops in the global financial markets as these traders unwind their positions suddenly.

Time to time,such fluctuations in the market will lead to good value investing ideas.Being patience and waiting for those fat pitches is what investing is all about.

Cheers,
Manpreet