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T.B. Kapali

Yen carry-trade appears to have gathered momentum in recent weeks

Chennai June 8 The yen carry-trade has acquired renown (notoriety for some) as one of the classic speculative strategies of all time in financial markets. The practice of borrowing at ultra cheap rates in the Japanese currency and investing in higher yielding assets — be it foreign exchange, bonds, equities, real estate or just about anything — has been well honed for many years now.

In recent weeks, the carry-trade express appears to have gathered further momentum or has at least regained the momentum which seemed to be slipping in the last quarter of 2006/earlier this year when yen interest rates stirred a little from their deep hibernation of the past many years.

One is not sure how much of the yen carry-trade speculation in global markets has graduated to the level of arbitraging. From pure speculation, a certain level of hedging moves a transaction into the category of an arbitrage.

But, the continuance of the current level of Japanese interest rates — around 0.5 per cent in the overnight inter-bank market — and the rate increases/firmness in other economies — be it Australia, New Zealand, the Euro-zone, the UK and last but not the least the US, indicate that the level of speculation would continue to be quite high.

Risk-free money

If not uncontrolled speculation, the current level of money market rates in India also seem to provide good potential for a limited amount of speculation/arbitraging to earn risk-free profits. Indeed, with the overnight inter-bank rate around 0.35/0.4 per cent and a range of instruments comprising foreign exchange, local money market instruments such as commercial paper and certificates of deposit to choose from, there seems to be some potential here for making risk-free money.

At the first level, the sub 1 per cent rates in the local inter-bank market would enable banks to fund a dollar position — which will earn overnight rates of around 5.3 per cent — at a spread of close to 5 per cent.

Speculation

The amount of speculation which can happen through this window would be a function of a bank's regulator-approved position limits as well as importantly, the bank's own internal risk limits, its short-term view on the dollar/rupee exchange rate as well as the overnight call rate.

But, as in yen carry-trades, the very act of borrowing in a low-interest rate currency and using the proceeds to invest in a higher yielding currency keeps the exchange rate equation in the speculator's favour, for at least some time.

In the Indian situation, as mentioned above, the regulator-approved position limits on foreign exchange as well as the limits on call market borrowing could constrain overall speculation.

Still, it will be a reasonable surmise that the fall in the rupee's exchange rate in the past few days — from the 40.60 levels to the 41.15 levels currently — has been partly spurred by inter-bank speculation on the back of the ultra low call money rates.

Hedging, to reduce the level of risk in funding a dollar position through the overnight rupee money market, does not appear attractive at current market levels.

Non-bank markets

The low level of inter-bank markets lay the platform for some arbitraging in the non-bank markets also. This is purely a play on the differences obtaining in interest rates in the different segments of the rupee money market. The level of risk also could be reduced substantially by appropriate hedging operations.

Mutual funds, for instance, can technically borrow in the CBLO market at the current low rates and fund an asset position earning 8.5 per cent for a three-month period. Three-month commercial paper is currently quoting 8.5/8.6 per cent.

The re-financing risk in the overnight market (collateralised) can be hedged through an interest rate swap where the mutual fund pays a fixed rate and receives the floating rate (overnight inter-bank rate). The three-month swap against the overnight inter-bank rate is currently around 7.25 per cent. The spread for the fund is therefore 1.25/1.3 per cent (8.5-7.25 per cent).

To execute such a strategy, a mutual fund, of course, has to have an adequate stock of collateral. Such arbitraging, though, is definitely better than lending in the CBLO market, at current market rates, as mutual funds have been traditionally doing.

An efficient market should see such arbitrage opportunities vanish as quickly as they appear. It would be almost like there was no arbitrage potential in the first place. Regulations, though, could play a part in preventing the market from acting upon arbitrage opportunities as and when they arise. It would then be like an opportunity cost, to be shared by the entire market.

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