An investment advisor claims that, over the past 13 years, he made a lot of money for various investors by means of Yen carry trades, using the yen as the funding currency and the US dollar as the target currency. He proposes to "do the same" for you now, using highly leveraged positions. Specifically, he proposes to execute carry trades, using 1-month or 6-month loans that he would then roll over. He claims that he is "able to obtain interbank rates for his transactions."

Please evaluate his claims of past success. To do so, you may assume that he is indeed able to trade at interbank rates.

Suggestion: you may wish to proceed by answering the following two questions:

a. Over the last 14 years, could he have made money from carry trades, using the yen as the funding currency (borrowing at LIBOR) and the US dollar as the target currency (depositing at USD LIBID or some other measure of the USD interbank deposit rate)?

Hint: Assume that he would have been continuously doing carry trades during the past 12 years, using 1-month or 6-month loans that you roll over. Describe the instruments he would have used to implement the carry trades, the roll-over strategy, gains/losses, etc.

b. What would the risks have been? Please show your work.

Hint: For example, what would have happened to his "bet" in Fall 2008? More generally, what does the distribution of the carry-trade gains/losses look like - like a normal distribution, or something else? If the latter, what is your interpretation? Is the mean statistically different from 0?

Answer rating: 100% (QA)

SOLUTION a It is certainly possible that the investment advisor could have made money from yen carry trades over the last 14 years as there have been periods during which this strategy has been profit... View the full answer