Monday July 28, 2008 - 05:15:23 GMT
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Yen Cross Basics
Three terms have resurfaced in the currency markets recently,
carry trade, risk aversion and risk appetite.
The euro/yen cross is once again popular. Have world economic and financial conditions
so improved that this risk barometer is again an active trade?
A little more than a year ago, in June 2007, the American dollar
was worth 124.00 yen. That month it began falling against the Japanese currency
and by late March of this year it had landed at 96.00 yen --an astonishing 23%
slide in ten months. Over a slightly
later period, August 2007 to July this year, the dollar fell a comparable
amount against the euro, dropping 20% in value from 1.3350 to 1.6037. But since
then the yen and the euro have parted ways against the dollar.
On Friday the dollar closed at 107.90 against the yen, a 43%
recovery of the 124.00 â€“ 96.00 decline. But against the united currency the
dollar finished the week at 1.5700, a bare 13% recovery of its 1.3350 â€“ 1.6037 decline.
The difference is the euro/yen. This cross has erased the entire credit crisis
inspired collapse when it sank from just over 169.10 to 149.26 in two months. On the 17th of this month it
reached a new all time high at 169.96. The dollar has hardly improved versus
the euro but it has surged against the yen. Is the euro/yen the biggest factor in the
dollarâ€™s return against the yen? The euro/dollar
rate gets most of the media focus but for currency traders the cross has been
where the action is.
But that brings us to another question. The precipitate
decline of the US currency
over the past year has most often been portrayed as a US problem. Dollar weakness is the result of the
interlocking housing and credit crises in the United
States, their effect on the US economy and the Federal Reserve rate
response. But is more happening? How can we disentangle the strands?
The dollar has
benefited from euro/yen strength. But so has the euro. Both are supported when
the cross rises because the euro/yen is calculated by multiplying the two
individual dollar rates. Euro/usd multiplied
by usd/yen produces the euro/yen cross rate
The primary Japanese factor in the movement of the dollar
yen, as the pair is called in the interbank market, has been the static nature of
the Japanese economy and Japanese interest rates. For almost six years prior to
mid-2006 the Bank of Japan had a zero rate policy. When
the Bank of Japan (BOJ) finally raised rates to 0.25% in July 2006, the bank
governors envisioned a slow return to a normal rate environment. But the persistence of deflation until last
August, and the fear of the prior deflationary decade inhibited the BOJâ€™s
ability to increase rates.
The bank last raised the overnight call rate by 25 basis
points to 0.5% in February 2007. Since
then it has been almost a year an a half with no credible threat of a rate
increase. The BOJ may desire higher rates but the difficult state of the
worldâ€™s financial system and the potential for a serious slowdown in the United States have
prevented a hike. Even though the inflation rate in June was 1.9% annualized
there is little expectation for a BOJ hike. Real interest rates in Japan are
negative. For a borrower, that is a large enticement.
The Fed Funds rate in the US has been cut 325 basis points
since last September. It is now 2.0%.
The European Central Bank (ECB) last raised it base rate 25 basis points
to 5.25%. For a trader, the enticement
The carry trade is
said to consist of borrowing yen in Japan
at low cost to invest in Europe (or New Zealand
at high return. As long as the yen does not climb in value against the deposit
country currency the rate differential is guaranteed.
It doesnâ€™t really matter if the yen is borrowed from a bank
and then sold or if it is simply a long euro/yen position opened for
speculative reasons; the result in the currency market is the same. The holder
of the position earns the rate advantage on the overnight roll and takes the
risk on the currency movement. .
A long euro/yen position earning the differential between
the euro and yen base rates results in the euro being forced higher and the yen
lower. A long euro/yen position buys euro and a sells yen. Every holder of a
long euro/yen position, from the largest hedge fund to the smallest retail
trader, puts euro purchases and yen sales into the currency market. However
that is not the end of the story.
All currency trades are paired. The euro and the yen are
traded against the dollar as well as each other. A portion of any euro/yen deal
may be converted into its dollar/yen and euro/dollar components. This procedure
is called legging out of a cross trade, transferring the original cross
position into its components or legs.
A euro/yen purchase when
so converted ends up in a dollar sale versus the euro and a dollar buy against
the yen. The end product of a euro/yen
purchase can be a stronger euro and a stronger dollar (against the yen). If the dollar overall is weak it is possible
for all the adjustment to be on the euro side, that is the euro dollar rises much more than the dollar yen to keep
up with the higher euro/yen rate. But
most of the time the euro/yen rate is absorbed across both the dollar yen and
the euro dollar.
When the yen crosses fall the reason usually given is that
the carry trade is risk averse. When the crosses rise traders are said to have
regained their risk appetite. What exactly does risk mean in relation to the
yen crosses? To the euro yen position holder risk aversion means that the advantage garnered by holding euro against
yen over time from the interest rate edge can quickly and easily be swamped by
movement in the value of the cross itself.
Take an unsophisticated example. The difference between euro and yen base rate
is 4.75%. With no other charge (in reality all institutions charge for an
overnight position) a move of 4.75% in a year in the value of the cross would negate
the earned rate advantage. In just two
months last year the euro yen lost 12%. This year it regained the same amount. Both moves had substantial impact on the
trading rates of their component currencies, the euro dollar and the dollar
The yen crosses can and do affect the trading rates of their
components, the euro and the dollar, in ways which do not relate to the
economic currents between the Eurozone and the United States.
FX Solutions, LLC
Chief Market Analyst
IMPORTANT NOTICE: These
comments are for information purposes only. Past results are not
necessarily indicative of future results. FX Solutions, LLCÂ® believes
that customers should be aware of the risks associated with
over-the-counter, spot Forex. Forex trading is highly speculative in
nature which can mean currency prices may become extremely volatile.
Forex trading is highly leveraged, since low margin deposits normally
are required, an extremely high degree of leverage is obtainable in
foreign exchange trading. A relatively small market movement will have
a proportionately larger impact on the funds you have deposited. You
may sustain a total loss of your funds. Since the possibility of losing
your entire cash balance does exist, speculation in the Forex market
should only be conducted with risk capital you can afford to lose which
will not dramatically impact your lifestyle.
To the best of our ability,
FX Solutions believes the information contained herein is accurate and
true. We reserve the right to make corrections and/or update the
material when deemed necessary. Therefore, FX Solutions assumes no
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