Carry-trade risk

The risk of the yen carry trade is a stronger JPY when the loan needs to be repaid. Fortunately for carry traders after the CNY began to float in July 2005, the JPY weakened against the USD into late 2005 as the interest rate differential between the U.S. and Japan expanded.

This changed suddenly on Nov. 23, 2005. Volatility on three-month JPY forwards jumped higher and continued moving strongly higher into mid January. The spot JPY bottomed on Dec. 7. Both measures continued to firm on Dec. 15 when the Bank of Japan first warned it might have to end its quantitative easing program.

The timing of the respective market bottoms well prior to the news might seem a little suspicious, but that is a story for another time and place. (It is called Japan, Inc., for a reason.)

If the market was short the JPY, as it must have been given the obvious trend, then the rise in option volatility should be interpreted as currency traders buying insurance against a stronger JPY.

Option volatilities in February and March fell below their January highs but surged in April as the market began to speculate the Chinese would move to revalue the CNY at a faster rate. Volatilities surged in the aftermath of Chinese Premier Hu Jintao’s visit to the U.S. This suggests those short the JPY suddenly became more fearful of greater strength in the currency. The purchase of option protection on the JPY rather than exiting the carry trade outright makes sense, as the yen carry trades are still highly profitable.