October 22, 2008 / 10:26 AM / in 10 years

Carry trade derivatives turn toxic for Japan markets

TOKYO (Reuters) - When the credit conflagration morphed into a full-fledged panic in financial markets this month, the major stock market that plunged the most was Japan’s — one of the countries least affected by the crisis.

The same week that the U.S. S&P 500 dropped 18 percent and London’s FTSE lost 21 percent, countries at the heart of the global financial crisis, Japan’s Nikkei average crashed by a quarter even though its banks and money markets have been relatively unscathed.

In Japan’s case, a sell off already underway was given an extra push from securities dealers who were forced to sell Nikkei futures contracts, among other assets, to hedge their exposure to risky bond-like instruments they had underwritten.

Ironically, the hedge selling was triggered by a fall in the market, so a further drop in the Nikkei could spark another chain reaction.

“People are worried about the next wave,” said Freddy Lim, chief Japan interest rate strategist at Morgan Stanley. “A lot of people were getting crushed.”

The instruments, such as power reverse dual currency notes (PRDCs), have been a popular form of carry trade among individuals and regional Japanese banks — using the yen as a cheap source of funds to buy higher-yielding currencies and assets.

These structured derivatives prospered when volatility was low, but now they are saddling investors with losses while creating tight linkages between markets.

When the Nikkei fell sharply, for example, the Australian dollar dived against the yen and long-term interest rate swaps fell sharply in both Japan and Australia.

During the height of the global stock market sell off earlier this month, Nikkei stock futures saw wild swings of 10 percent a day over the course of a handful of trading sessions.

Some analysts said this smacked more of panicky hedging in a thin market than any change in investor sentiment based on the corporate earnings outlook.

Price moves were exaggerated by the absence of counterparties as the likes of Wall Street banks and hedge funds scurried to the sidelines to avoid risk at all costs as the crisis worsened.

The futures slumped 1,360 points at the open on Friday October 10, capping off the week the Nikkei slumped by 24 percent in a drop that was twice as big as its weekly fall in the 1987 crash.

In the same week, the Australian dollar shed 16 percent against the yen, by far the biggest fall on record.

After such a steep plunge, one-week implied volatility on Aussie/yen was quoted for a few days at 80/100 percent by broker GFI. Even now, it is quoted at 45/75 percent. Before the crisis, it was near 10 percent.


Dislocations also hit the yen swaps market due to the twin plunges in the Nikkei and the exchange rate between the Australian dollar and the yen, or the Aussie/yen.

Investors and banks use swaps to adjust their exposure to interest rates by locking in fixed or floating rates. Because the contracts are privately negotiated, the rate paid or received in the contracts is typically higher than yields on ultra-safe government bonds, creating a positive spread.

But the extreme hedging and lack of liquidity drove the 30-year yen swap rate down 65 basis points in just a week, taking it below the 30-year government bond yield by a huge 60 basis points on October 10, when the Nikkei plunged to a 5-1/2-year low.

By Wednesday, that spread had pushed back slightly to near minus 34 basis points but still far away from the positive 15-20 basis points typically seen in normal trading conditions before the credit crisis.

As a result, the correlation between Aussie/yen and the 30-year yen swap rate is very strong at a positive 89 percent after having been typically negative before the credit crisis struck, meaning they tended to move in the opposite direction.

“Whether the structure is tied to moves in dollar/yen or the Nikkei, it’s a structured bid in the long end,” said the head of yen interest rate trading at a European bank.

“One thing different this time is there’s no real capital or leverage offered by the Street or the hedge-fund community to take the other side of this. That’s what gives you these outsized moves.”


Analysts estimate that issuance of the structured notes totaled more than $10 billion annually in recent years as the carry trade flourished.

One example was a power reverse dual currency note sold by Commonwealth Bank of Australia in late June.

Australia’s steep 7.25 percent interest rate earlier this year — compared with Japan’s lowly 0.5 percent rate — made the Aussie dollar a big favorite for such structures.

The note’s structure had a 30-year maturity and offered a 12.5 percent coupon the first year, Informa Global Markets reported. After that point, the coupon was tied to Aussie/yen, rising or falling with it.

Typically in such a structure, a plunge in Aussie/yen below a certain round level like 80 yen or 70 yen where the option triggers are placed, means the bonds are unlikely to be called, or terminated, by the issuer and will turn into a long-term yen bond instead. These embedded options are what give the PRDCs their juiced-up coupons.

The products usually include a clause allowing the issuer to terminate, or call, the product.

For that reason, the market makers that created and sold such structures are forced to hedge themselves in long-term interest rates as well as Nikkei futures, the Aussie and the yen.

Editing by Neil Fullick

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