Futures: The Easiest Way to Play the Yen Carry Trade

Tired of seeing hedge funds have all the fun? Want to play the Yen Carry Trade (YCT) like the big boys? Well, all you need is a futures trading account and you too can make huge, leveraged bets that the dollar will stay strong against the Yen. Of course you'll get wiped out like the rest of them if the Yen gets stronger in a hurry.

Here are some quotes for the Dollar/Yen on the New York Board of Trade futures markets. Notice that:
the June '07 contract closed at 121.325 Yen to the Dollar, while
the September '07 contract closed at 119.925,
the December '07 contract closed at 118.610, and
the March '08 contract closed at 117.360.

These prices reflect the interest rate differentials for Yen and Dollars. If you sell Yen by purchasing any of these futures, and the Dollar/Yen exchange rate remains constant, then the value of your futures will gradually rise over time. Buy enough futures contracts and you'll have a highly leveraged bet on the Yen appreciating relative to the dollar at a rate less than 4.5% per year. Here are some Yen/Dollar contracts graphed:



When you buy (Dollar/Yen) or sell (Yen/Dollar) the appropriate futures, the counterparty is typically a large banking institution like JP Morgan, Citigroup or Goldman Sachs. The big banking houses will usually then hedge their futures positions by borrowing actual Yen and then selling them for dollars on the Foreign Exchange markets. Together with the banks, your trades will amount to a full blown YCT that helps prop up the dollar and fuel America's excessive consumption.

The difference in Japanese short term rates (0.5%) and US short term rates (5.25%) is generally enough for the commercials to score a nice profit on the fully hedged position. If the exchange rate stays constant, you get around 4.5% with considerable risk, while they get around 0.25% with little or no risk. Of course fees, commissions and spreads cut into everyones profits. The numbers above are just for illustrative purposes.

Here's a nice chart showing the open interest as well as the relative positions of commercials and large and short speculators as reported to the Commodity Futures Trading Commission:



A year ago, Open Interest in futures contracts was low and the Commercials had gone short the Yen after a big unwinding of the YCT. Since then there's been a substantial increase in the size of the YCT, as reflected in futures positions, with two notable dips along the way (Oct-Nov & Feb-Mar). Neither of those dips in YCT positions was enough to push the commercials into being short Yen futures, but both coincided with sharp drops in the dollar relative to the Yen:



The Yen has been trending down against the Dollar since the beginning of 2005 when the interest rate differential between the US and Japan got large enough to make the YCT attractive. With commercials again very long Yen futures and rates more stable of late, it appears that the Dollar is poised for another sharp decline relative to the Yen. Of course the YCT could get more overextended before the next decline begins. Betting against the YCT can result in a very long, painful waiting game, as most small futures speculators have discovered this year.