The Demise Of The "Yen Carry-Trade"

The Japanese Yen surged as much as 10 percent against the dollar last week. In the last month, it has gained an astounding 34 percent against the euro. I am sure you might be wondering "So what? How does that affect me?" Let me try and explain.

The Yen's rise suggests that the pace of "financial de-leveraging" is accelerating. The global financial crisis seems to have brought a sudden end of one of the world’s biggest easy-money schemes, the so-called yen-carry trade.

The Japanese economy never really recovered after the collapse 20 years ago. To stimulate the economy the Bank Of Japan lowered interest to the point that effectively interest rate in Japan went to zero. Also, the Japanese are a frugal lot, amassing savings to the tune of trillions of dollars.

For much of this decade, Japanese and foreigners alike borrowed money in Japan and invested that money in higher yielding assets across the world, from home loans in America to equities in Mumbai. This turned Japan, with its $15 trillion in personal savings built into a provider of low-cost capital for the rest of the world.

No one knows for sure how large this outflow was. Much of the yen-carry trade took place beyond public scrutiny, in the form of currency options or other types of derivatives trading. Its size is believed to have been to the tune of hundreds of billions of dollars per year. Some of the biggest players in the carry trade were American and European hedge funds and banks. But Japanese individuals also fed the outflow of yen by pouring their savings into overseas investments, like emerging markets funds, in search of higher returns.

A simple example of the yen-carry trade is:

1. Borrow Japanese Yen at the rate of say 1%pa and convert the money into US Dollar.
   
2. Invest that money in a fund operated by a Singapore/ Hong-Kong based FII(Foreign Institutional Investor) who is allowed to buy/sell shares in India. The FII converts the dollars to rupees and buys shares of companies listed on the Bombay Stock Exchange. Assume that in 1 years time, the shares have increased in value by 20%.
3. Sell the shares, convert the rupees to dollars and the dollars to Yen. Repay the borrowed money with interest. Pocket the difference of 19%.
   

Main risks involved that the investor has to face are the stock market risk and the currency risk. This works perfectly when the markets are rising, but when the market turns, the gains turn into losses. This leads to a stampede for the exit causing a further fall in the market. The process feeds on itself, a sort of positive feedback loop. The results are visible on the screen. Huge falls in stock prices all over the world, massive sell-offs in the commodities market(oil, base metals, agricultural commodities etc), collapse of currencies(Indian Rupee, Korean Won etc).

I don't know how/when the crisis will be resolved. However one thing is clear: Huge currency speculation of the kind that made the currency carry trade a cornerstone of global finance in recent years is highly destabilizing. When this crisis is over, the authorities should aim to reduce it.

Launch Of Chandrayaan 1

At 06:22 Hrs October 22, 2008 Indian Standard Time (IST) the Indian Space Research Organisation’s (ISRO’s) Polar Satellite Launch Vehicle, PSLV-C11, successfully launched the 1380 kg Chandrayaan-1 spacecraft into space. PSLV-C11 is the uprated version of ISRO’s Polar Satellite Launch Vehicle in its standard configuration.

The mission is scheduled to last two years, prepare a three-dimensional atlas of the moon and prospect the lunar surface for natural resources. The 11 payloads (scientific instruments) carried by Chandrayaan-1 include five instruments designed and developed in India, three instruments from European Space Agency (one of which is developed jointly with India and the other with Indian contribution), one from Bulgaria and two from the United States.

The moon mission, in addition to demonstrating technological capacity, can potentially yield commercial gains for India’s space program. India’s ability to put satellites into orbit has already resulted in lucrative deals; for example, Israel has sent up a satellite by means of an Indian launcher.

Considering NASA's multi-billion dollar budget, this indigenous effort by ISRO achieved in the face of budget constraints deserves praise.

Ban On Short-Selling Is Short-Sighted

Short-selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.

Short sellers are widely regarded with suspicion because, in the views of many people, they are profiting from the misfortune of others. Some businesses campaign against short sellers who target them, sometimes resulting in litigation.

However, the people advocating a ban on short selling ignore that fact markets by defination go up and down. Markets are not "meant" to always go higher. Thus, short-selling is an integral part of any market. Also, securities that have been sold short have to be "covered" i.e. bought back. Thus, in rapidly falling markets one of the most important "buyers" are short sellers who are trying the buy back the securities they have short-sold.

Importance Of Short Selling

1. Restrictions on short-selling disturbs the markets price discovery mechanism. Analysis of market data has proved that shocks in which short positions were present had lower impact cost(defined by the difference between the bid and offer prices) compared to similar stocks with no short positions.
   
2. Many trading strategies like "convertible arbitrage", "statistical arbitrage" (or "stat arb") or the typical "long-short" strategies depend on having the ability to short-sell. Noted investor Warren Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.
3. Viability of the options market (without shorting, an options desk cannot run a delta neutral book - it has nothing to do with being bearish or bullish on the stock in question)
4. Mutual Funds, Pension Funds and other institutional investors have stock loan desks which lend stock to short-sellers to earn return on idle securities
   

Anyone who seriously thinks that the cause of the current crisis is the actions of evil and manipulative speculators lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets. Short selling may well exacerbate existing problems, but it certainly was not the cause.

Worry About The Credit Crisis

What is the most important part of a house? Is it the garden, the living room? Maybe it's the kitchen. Actually, it is the electrical wiring and the plumbing - the bits you cannot see. So it is with financial markets. The stockmarkets are the most visible part of the system. The money markets, however, are the plumbing of the system. Normally, they function efficiently, allowing investment institutions, companies and banks to lend and borrow trillions of dollars. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty mess.

First, the problem. It is widely assumed that central banks (The Reserve Bank of India, for example) set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). Normally, these are only a fraction of a percentage point above the official interest rates.

In the last few months the spread between the Libor and the Fed Funds Rate has widened to almost 200 bps(basis points). The width of the margin reflects investors’ worries about the strength of the banks. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman.

Why do these markets matter? First, the rates on loans paid by many consumers (floating rate home-loans, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would worsen.

Deprive a person of oxygen and he will turn blue, collapse and eventually die. Deprive economies of credit and a similar process kicks in. So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.

BSE Sensex Falls Below 10000

The stock market witnessed a sell-off on Friday with the BSE Sensex closing below the 10000 point level for the first time since July 24, 2006. It took 484 sessions for the Sensex to climb from 10000 to its all-time high of 21207. However, in just 191 sessions all the gains of the last 2 years were erased.

What can be expected going forward? Is there any respite in sight? During times like these, it helps to look back at previous bear-markets. As they say, those who don't learn from history are destined to repeat it.

Analysis of previous bear-markets suggests that bear-markets take a minimum of 12-18 months to complete. Measured from January 2008, we are just in the 10th month. So, it will be atleast 6 months before stocks start recovering. I guess the price-wise damage is nearing an end. Historically markets bottom-out at 9-10 forward PE multiples. Considering 2009 March Sensex EPS estimate of 900-950, we are near the bottom.

Investors(both old and new) should use the next 6-9 months to build a portfolio of stocks which they should be prepared to hold for 2 years at least. This strategy is sure to yield returns in the long-run.