Please excuse my noobish questions but I've just been reading about yen carry trades and there's a couple of things I'd like to understand: 1- you short the yen and buy a high-yielding currency, then pocket the interest difference 2-at this point, you're open to (often leveraged) currency risks 3- what would happen if I wanted to hedge the currency risks? can I do that with futures? 4- if it can be done, it sounds a lot like arbitrage to me: what's stopping me from borrowing a LOT of yen and pocket the free % with 200:1 leverage?
You can't hedge the currency risk. A future is in effect a forward spot deal and so the price reflects the interest differential. ie that is why the future is never the same price as a spot deal unless the interest rates of the 2 currencies are identical.
Wouldn't it be possible to hedge the risk with options on futures? Short the yen in the cash market and then buy calls on future contracts for delivery of yen.
> Short the yen in the cash market and then buy calls on future contracts for delivery of yen. You have to reduce the carry trade interest by the cost of the option premium: ~ Sideways - you make the interest & lose most or all of the premium. ~ Yen drops - you make the interest, lose the premium, & profit on the currency trade. ~ Yen rises - if the option gain perfectly balances the short loss, you make the interest. To the extent it doesn't, you subtract from the interest or lose.
What's stopping you is a margin call. Try it on a demo even with 100:1 leverage and see how many hours or days at most your yen carry trade lasts, i.e. avoids a margin call. At that kind of leverage, the premium to hedge with options would kill any "arbitrage" many times over.
IMM Data: Short USD Positions Increase/Specs Very Long Carry Saturday, July 21, 2007 6:20:00 PM Sydney, July 22: There was a bit of a shakeout of the carry trade on Friday and the IMM data released that same day partly explains whey. Currencies that are the main beneficiaries of the carry trade are the CAD, GBP, AUD, NZD and MXN. Friday"s IMM data showed that the speculative market was net long a staggering combined total of 316,500 contracts against those currencies while running a combined net short 162,000 contracts against the main carry trade funding currencies the JPY and CHF. The net long GBP/USD contracts blew out to a record 98,366 from 88,531 the week before. The net short USD positions held by the IMM specs grew to 253,600 contracts from 235,600. For a full rundown of the IMM data see^^^^2381^.
What exactly do you want to do? Are you trying to trade Forex or Currency Futures? They are not the same. If you are trading Yen in the Futures market, you have two options to make money while protecting yourself. 1. If the Yen futures prices are low and trending upward, you do a bullish insured Yen trade. In order words, you buy a Yen Futures contract and also buy an in-the-money Yen put option as insurance. 2. If the Yen futures prices are high and trending downward, you do a bearish insured Yen trade. This means, you sell a Yen Futures contract short and also buy an in-the-money Yen call option as insurance. There are several other combinations you can do with Yen call and put options without the actual Yen futures. You can also trade the Yen Future against USD Future and create a spread, just like in Forex. You can do the same with the Swiss Franc or Euro. There are so many ways to make money in the currency futures market. You just need to educate yourself thoroughly and specialize.