EclectEcon

I'm generally pretty ignorant when it comes to international finance and exchange rate determination, so can someone please tell me why this is an equilibrium (from Steve Poloz):

The yen carry trade can take on a variety of forms, but at the heart of each is a loan taken out in Japanese yen, the proceeds of which are used to invest in financial assets elsewhere in the world. It takes advantage of the fact that Japanese interest rates are extraordinarily low, while other countries' interest rates are much higher. For example, an investor can borrow yen from a Japanese bank, convert the funds into Canadian dollars, buy a Canadian government bond, and earn an interest rate spread of around 4%.

The best part of this investment strategy is that the investor makes a 4% spread return on the entire structure, most of which is not his money. He may be required to put up 5% or 10% collateral with the bank - essentially investing $5 of his own money to buy $100 in Canadian bonds, thereby earning a $4 return on just $5 invested, or effectively 80%. Layered on top of the structure is an expectation that the Japanese yen will continue to drift down while the Canadian dollar may continue to appreciate - another positive return.

Why haven't speculators/arbitragers been doing this to the nth degree, driving up Japanese interest rates and driving down Canadian interest rates? And why hasn't this caused expectations of future apprectiation or depreciation of the relevant currencies? How can this be an equilibrium that lasts longer than a few nano-seconds, much less months or even years? Why aren't fund managers and investors doing this with even bigger chunks of their portfolios? Is the risk of future foreign exchange movement so high? Really????

Steve's answer, which doesn't completely persuade me, is that, yes, exchange rate risk is at work here.

The problem with these structures is the potential for an abrupt unwinding of positions. An investor who decides to take his $5 out of the market sells $100 in Canadian bonds, sells $100 of Canadian dollars, and buys yen to close his position. Accordingly, a shift in expectations about monetary policies or currencies can lead to a very rapid evaporation of positions and huge moves in exchange rates.

The bottom line? The yen carry trade is a legitimate tool for many financial institutions. But, like many synthetic financial structures, its over-use as a wagering tool runs big risks, both for the investors and for the global financial system at large.