* WHAT TO DO NOW: COME OUT OF THE WOODS! This entire lesson is the first part of a two lesson Case Study that reviews a currency investment which began in 1994. See below.
Silent shadows, children of dusk, are born with the setting sun. They are quiet images of pine that lengthen across the forest floor, darkening with the dying day. Pencils of twilight filter through the trees. The iciness of winter falls. All is quiet and calm as I sit at peace in this silent world.
Late 1993 in a quiet woods near Marshallville, Georgia. I wanted to clear my mind before thinking about investing in the year ahead. The greatest way I have found to straighten out my thoughts is to get away from the noise and static of society and listen to nature instead.
Watching the sun rise was the busiest activity of the day after a morning's hike and a hearty lunch of hot, thick split pea soup, rice and chunks of warm, fresh home made bread, eaten in the brisk winter's chill. I came upon a meadow, quiet and surrounded by young pine. It was a trap for the winter's thin, but warming afternoon sun. I parked myself against a tree for just a little rest. It turned into a deep, long totally rejuvenating sleep in the fresh air.
When I awoke, the stillness of dusk had begun. Shadows flickered through the trees. The stillness grew. Everything, even the crickets went silent. I just sat there until it was gone and even then it was so peaceful I didn't want to come out of the woods!
It was then and there I realized we all have to come out of the woods sometime and that simple thought led me to write a report about an unusual currency speculation that seemed very dangerous, but had enormous potential.
I invested in these ideas myself in early 1994 and what I learned from these investments can have a very dramatic impact on your currency strategies in the years ahead.
The investments I made were in the synthetic dollar strategy on a speculative basis and aimed at taking advantage of positive carry that was available in the markets at that time.
Since that time this investment has been through some good and bad times. You can learn much from each. You can see how investment projections can go wrong. You can learn how investors who speculate in currencies err when they use too much leverage and when they shorten their time span midstream. You can also learn how to adjust your currency speculation and how sticking to your targets can bring excellent long term profits.
I share all this that I personally learned from this currency speculation in a Case Study which starts next page.
We begin this study by looking at the essence of what I wrote (and invested in myself) in 1994. I include all of this to show the kind of thinking we should put into our currency decisions (especially if you are going to speculate!) I also include all of this so that you can understand how even after deep analysis, the currency markets do not always react as we expect.
You will see in this study how after deep currency analysis, I speculated on currencies and their interest rate returns and then everything seemed to go exactly wrong.
You will then learn how the safeguards I had built into my speculation protected the investment and allowed me to adjust my position. Then you will see how the long range targeting and positive carry in the speculation turned what seemed at first a disaster, into an excellent investment. Here is what I thought at the end of 1993:
I would borrow Japanese yen and invest in Mexican pesos!
The key to success in using collateral loans to create a synthetic currency position for speculation is to borrow a currency when it is strongest and invest it in a currency that has been weak but is about to become strong.
The yen had been very strong, but let's look at why I thought it would become weak in U.S and Mexican peso terms. At that time, I believed this to be a special opportunity for many reasons.
First, the Mexican government had actually been running a surplus in their budget.
Second, U.S. government debt was over three trillion dollars. This figure was hard for me to comprehend until I read an article in Parade magazine in which ex-Senator Barry Goldwater was interviewed. He pointed out the total value of the U.S. debt. He put it very clearly- "Everything, the forests, the farms, the gold, the copper, the people, everything- is worth less than 4.5 trillion dollars"! And our debt at that time was over 3 trillion and growing.
Third, the Mexican peso had been pegged in the 3 pesos per dollar range for the previous year. I reckoned that during the first year of NAFTA it would be less likely to be devalued than at anytime.
Thus one can conclude that there was good reason to believe that the Mexican peso would maintain its parity with the U.S. dollar.
But now let's look at why I thought the dollar would strengthen versus the yen (and the peso would strengthen against the yen as well).
Japan had had its troubles. Japan's success over the past 20 years brought many of the same ills we in North America and Europe had been suffering. High labor costs were forcing Japan to export many of its factories and profits.
One way Japan solved high labor costs was by exporting its business knowledge. It began to move its manufacturing facilities out of Japan. I believed Japan was waiting in the wings just hoping that NAFTA would fail. Failure would have opened a ripe opportunity for Japan to make Mexico into a major trading partner. Japan would have profited enormously in later years when the U.S. was forced to open up to free trade with Mexico. With all its faults, NAFTA at least moved the U.S. in the right direction and stopped the Japanese from getting a foothold in Mexico that the U.S. should have.
This short term loss to Japan was just one of many current setbacks to the yen. Yen problems were both fundamental and cyclical. Since 1975, the yen had suffered three periods of abnormal strength. The first was in 1976 to 1978 when it advanced 37% versus the U.S. dollar. The second was 1985 to 1988 when it rose 51% versus the dollar. The third, which we had just seen started in 1990. The first two periods of strength averaged 42 months in length. This third period of yen strength reached its 42nd month in October 1993. In this third period, the yen advanced 32% versus the dollar and 50% against European currencies.
After previous periods of strength, the yen sustained a period of weakness. After the last bout of appreciation in 1988 the yen dropped 25% versus the U.S. dollar.
The first two periods of yen strength were not hard on Japan's industry. Then the strength of the yen was offset by low Japanese wages. The first wave of yen strength in 1976 to 1978, the nominal increase in wages for Japan was 27%, but at the same time U.S. and German wages rose more (U.S. +37%, Germany 33%). The same was true in the second period of yen strength during 1985 to 1988.
In this third wave of yen strength this was not true. Nominal wages in Japan rose higher than in the U.S. U.S. labor costs were lower than in both Japan and Germany.
Also U.S. capacity utilization was lower than ever before, while Japan's capacity utilization was higher than ever before. (Utilization of capacity is a percentage of actual production compared to total production potential of a country.)
Thus this third wave of yen strength suggested to me that there would be yen weakness that did not exist in the first two waves of yen strength.
There were other reasons why I though the yen might well drop.
* Weakness factor #1: Japan's recession. The strong yen was creating high costs for Japanese products in the U.S. and other countries right at a time when the Japanese economy was in the doldrums. A review of the Global Economic Cycle showed that Japan and Germany were both in recession and had not yet reached the bottom of the economic cycle yet. This recession meant there were fewer buyers of goods in Japan. This put pressure on Japan's businesses to sell as much abroad as it could. A strong yen would make this much more difficult.
* Weakness factor #2: Lower yen interest rates. The recession in Japan would tend to push yen interest rates down. Lower yen interest rates would reduce demand for the yen (and cause its strength versus the U.S. dollar to weaken). The yen interest rate during that month fell for the first time in years below the U.S. dollar rate. This also reduced yen demand.
* Weakness factor #3: Important structural changes. Japan had really been canny over the past two decades. While saturating almost every market in the world with their products, they managed to keep up barriers which kept the inflow of foreign goods sold in Japan at an absolute minimum. This created huge trade imbalances all over the world. In the long run, I knew this could not continue. This had to be changed for at least two reasons.
The first reason was that the barriers had been bad for the Japanese consumer. The import barriers in Japan stopped Japanese consumers from gaining access to many superior (and now much cheaper) products abroad. Though Japanese industry would have liked to maintain the many barriers and keep Japanese customers as their captives, Japanese government deregulation would increase exports to Japan. The new government in Japan then was led by Mr. Morihiro Hosokawa was consumer oriented.
A second reason why I knew this change would come about was that the many nations who had huge trade deficits with Japan were demanding better access to Japanese markets. Japan had been good at giving in on this as slowly as possible, but they then had to help equalize these balances. I knew the time to do so was well past.
All this meant increased exports to Japan which would decrease the Japanese trade balance which would reduce demand for yen, which would add to the yen softness.
* Weakness factor #4: A weak stock market in Tokyo. There was continued room for weakness in Japan's stock market. Normally a stock market starts to rise at the stage of Japan's economic cycle. As interest rates drop, money shifts from bonds and deposits to the stock market. There were, however, several factors slowing the market there.
One factor was the hangover that continued from the enormous bull market of the late 80s. Another was that high Japanese labor costs were making businesses there less competitive and thus not so attractive at the very high price earnings ratios that existed in Japan.
These high labor costs also forced successful well-managed Japanese businesses to other Asian countries such as China, Taiwan, Indonesia, Singapore, Malaysia, etc. These alternative stock markets, full of successful Japanese subsidiaries with much more attractive price earnings ratios, were competing with Japanese shares.
I thought where could a person invest in the yen? Interest rates were low and falling, the stock market was in a bind and the value of the yen was falling! This was a classic scenario where money flees a currency and its value falls.
Now here is the interesting part! You could borrow yen at an even lower interest rate than the U.S. dollar. For example, Jyske Bank in Denmark was offering yen loans at 3.875%! It was possible because of this to make returns up to 96.72% in 1994.
Here were projections for an investment where I considered investing $25,000 in Mexican peso 3 month Treasury bills and using this investment to borrow $100,000 worth of yen which was then also invested in Mexican peso 3 month Treasury Bills.
This was just the beginning of the profit potential in this portfolio. I expected the yen to fall in value versus the U.S. dollar and hence the peso as well. The yen's fall could add an extra 52.10% of profit to the portfolio!
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN MODEL DEC. 1993 Convert $25,000 to Mexican pesos and buy Cetes 3 month T Bills Use the T Bills To borrow U.S. $100,000 of yen at 3.875%. Invest the loan in Mexican peso T-Bills as well.
$100k Mexican Peso Yield 12.00% less 3.87% 8.13% $8,130 Extra Earned From Loan $8,130 $25k Mexican Peso Yield 12.00% $3,000 TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 44.52% OR $11,130
In this model, the hope was that the peso/dollar parity would remain the same and the hope (and this hope was backed with great evidence) that the yen would fall versus the U.S. dollar in 1994.
If the peso and the dollar were likely to remain linked (as they seemed), and if the yen was likely to fall versus the U.S. dollar, then the yen was likely to fall versus the Mexican peso as well!
Let's look at what a fall of the yen (if this happened) would have done to the portfolio above.
A fall of the yen versus the U.S. dollar (from its level then of 108 yen per dollar) would have affected the model above dramatically if it fell 5%, 10% and 15%.
We assumed that we borrowed US$100,000 worth of yen at 108 yen per dollar, which provided us with 10,800,000 yen.
A fall of 5% would be 5.4 yen which would put the yen dollar parity at 113.4. Thus to buy back 10,800,000 yen would cost only US$95,238. We would add an extra $4,762 (or an extra 19% profit) if the yen fell 5%.
In total, if the yen fell 5% and if we have invested US$125,000 worth of pesos of which US$100,000 had come from a yen loan, we would make $15,892 return or 63.56%. We would make 44.52% ($11,520) from the loan spread and $4,762 or 19.04% in foreign exchange profit.
If the yen fell 10%, the yen dollar parity would be 118.8. It would cost only $90,909 to buy the $100,000 worth of yen to pay off the loan. We would make $9,091 or 36.36% of forex profit.
In total if the yen fell 10% versus the U.S. dollar, we would gain US$20,221 on each $25,000 invested or 80.88% total. We would make 44.52% ($11,520) from the loan difference and $9,091 in foreign exchange profit.
Now let's look at a 15% yen drop which would bring it to 124.2 yen per dollar. It would cost only $86,950 to pay off the yen 10,800,000 loan. We would make $13,050 or 52.1% in foreign exchange profit.
In total if the yen fell 15% versus the U.S. dollar we would gain $24,180 on each $25,000 invested or 96.72%. We would make 44.52% ($11,500) from the loan difference and $13,050 from foreign exchange.
The big question was "Could the yen fall 15%?" After the last wave of yen strength (it rose 51%), it fell back almost half the amount it rose. It fell 25% in two years. If the yen fell half as much as it has risen in this third wave (it rose 32%), it would fall 16%!
So there were many reasons at that time to believe that the yen - peso collateral loan could be a top winner for 1994.
But I wanted to look at the risks! If the yen can fall 15%, we must also conclude that it could rise 15%. This seemed unlikely in light of the evidence we have seen, but we should always know what will happen if our expectations are not met. We must review the risk in case our research misses something or we draw incorrect conclusions or the statistics and data we use is wrong. We must prepare for the unexpected!
Let's look at five risks that we faced.
* Risk #1: The bank where we hold our money goes broke. This is one of the least risks if you deal with a major bank. We looked at a number of international banks. Many of them were major international institutions. Others were very small banks. I felt comfortable with all these banks, but looked at ways to increase that comfort. Here are steps to make sure you are comfortable too.
#1: Look at the bank's balance sheet.
#2: Look at how long the bank has been in business.
#3: Ask if there is any type of government or industry guarantee on your account.
#4: See if the assets the bank will hold for you will be held by the bank as a fiduciary. If so, even if the bank goes broke, the assets should be safe unless fraud is involved.
#5: Ask a banker or investment professional you trust to get a credit rating or reference on the bank.
* Risk #2: The Mexican government could default on its obligations. Even though Mexico had initiated significant reform and NAFTA had passed, the Mexican government's debt rating was still not of a high standing. Mexico's debt load from money borrowed in the 80s is still high, so we must take this risk as a major consideration. According to Standard & Poor's, one of the best known credit rating agencies, the Mexican government at that time was rated BB+ and the outlook was stable. BB is not a Standard & Poor's investment grade rating. It is a speculative grade rating. Standard and Poor's defines their ratings AAA, AA, A and BBB as investment grade. BB, B, CCC, CC and C are speculative grade ratings. Mexico at a BB+ had the highest grade speculative rating, but we must keep in mind that this investment is a speculation.
Standard & Poor's describe a BB rating as, "One with less near- term vulnerability to default than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments."
We did not discount this risk factor. We realized that this investment was a leveraged investment into a speculative issue.
There were many positive factors that mitigated this risk. The fact this speculation involved only short term instruments (90 day T-Bills), that they are government debt and that Mexico would seem least likely to default right after the beginning of NAFTA were all positive factors that suggested the risk was minimal. The fact the return on these T-Bills had dropped (they paid over 17% last year) was a signal that the market was gaining confidence in Mexico's economic stability.
We needed to understand and decide whether or not to accept this risk. We could not ignore it!
We recognized the reason this investment offered such high potential was because the international market place rewards those who take risk. We were being paid to back our belief that Mexico had changed and was changing even more for the better. If we were right, we would be well rewarded. If wrong, we could lose all and as you will see, we could lose even more than we invested!
* Risk #3: The returns that Mexican Peso T-Bills offer could fall. If the Mexican economy had strengthened and the perception of risk in holding these investments diminished, it was possible that the return on these T-Bills would fall. As an example, let's look at what would happen to our investment if the yield dropped from 12% to 10% or 8%.
There was no guarantee that the yield on these T-Bills will last longer than 90 days. These instruments are bought at a discount for 90 days. At that time, a thousand pesos worth of these bills could be bought for about 970 pesos. For the 970 pesos, the bill promises to pay 1,000 pesos in 3 months (90 days). Thus one could roll them over four times a year. If the discount remained stable, slightly over (if compounding is taken into account) 120 pesos of profit could be made. The actual return was about 12.6%, but after converting to pesos and costs the return was just under 12%.
For projection purposes, we assumed an investment of US$25,000 into Mexican pesos "Cetes" T-Bills. This was used as collateral for a US$100,000 loan also invested into Mexican peso Cetes T-Bills.
Keep in mind that when we looked at these performance projections we were looking only at the return before foreign exchange profit or loss. We would need also to look at the foreign exchange portion of the profit in detail.
Convert $25,000 to Mexican pesos and buy Cetes 3 month T Bills Use the T Bills to borrow U.S. $100,000 of yen at 3.875%. Invest the loan in Mexican peso T-Bills as well.
$100k Mexican Peso Yield 10.00% less 3.87% 6.13% $6,130 Extra Earned From Loan $6,130 $25k Mexican Peso Yield 10.00% $2,500 TOTAL RETURN ON $25,000 INVESTED IS 34.52% or $8,630
$100k Mexican Peso Yield 8.00% less 3.87% 4.13% $4,130 Extra Earned From Loan $4,130 $25k Mexican Peso Yield 8.00% $2,000 TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 24.52% or $6,130
As you can see from the projections above, every time the return on the Cetes T-Bills falls 1%, the return on your portfolio falls 5%. With this knowledge we could project in advance the actual return (without the foreign exchange profit or loss factor) at each level of T-Bill yield:
T-Bill Yield Portfolio Return 12% 44.52% 11% 39.52% 10% 34.52% 9% 30.92% 8% 25.92% 7% 20.92% 6% 15.92% 5% 10.92%
* Risk #4: The interest rate on the yen loan could rise. Normally our banker would not give us a fixed interest rate on our yen loan. The normal collateral loan is linked to the London Interbank Interest Rate and could change at any time. As with the peso yield fall, every 1% rise in the interest rate of the yen loan would reduce our return by 5%. The portfolio return projections above can thus be applied to see what happens to our profit if the yen interest rate were to rise.
Again all of the above had been calculated without taking the foreign exchange fluctuations into account. However, foreign exchange fluctuations between the yen and peso could have the biggest impact of all on this portfolio. It can bring the biggest profit, but also create the biggest loss! This is the fifth and largest risk.
* Risk #5: The Mexican peso could fall versus the Japanese yen. We saw how a 5%, 10% and 15% fall of the yen could add enormous profit to this portfolio. Now we need to look at how a 5%, 10% and 15% rise of the yen would destroy the profits of this collateral loan.
In the projections below, I calculated the projected losses in U.S. dollar terms, but if the peso fell versus the U.S. dollar, it could be that the yen rises versus the peso, but not the U.S. dollar. The results in real profits or loss would be the same, whether the U.S. dollar falls or not.
As we reviewed earlier in our projections we had borrowed 10,800,000 yen when the US$/Yen rate is 108.
If the yen rose versus the dollar (and hence the peso) by 5% the dollar/yen rate would be 102.6. It would cost US$105,263 to pay off the yen loan. The foreign exchange loss is US$5,263 or 21% of the US$25,000 invested.
In other words, a 5% rise in the yen versus the peso would reduce the return on the portfolio from US$11,130 to US$5,867 (assuming the yen loan rate and the peso T-Bill yield did not alter) from 44.52% to 23.52%.
If the yen rises 10% versus the dollar, the dollar/yen rate would be 97.2. To pay off the 10,800,000 yen would cost US$111,111,111. The portfolio would suffer a US$11,111 loss or 44% of the US$25,000 invested. This would reduce the 44.52% profit to almost nil.
In other words, a 10% rise in the yen would reduce the return on the portfolio from $11,130 to $29 or almost no return at all. If the yen rises 10%, the portfolio would have just broken even.
If the yen rose 15% versus the dollar, the dollar/yen rate would be 91.8. To pay off the 10,800,000 loan would cost US$117,647. The portfolio would suffer a US$17,647 loss or 70% loss of the initial $25,000 invested.
In other words, a 15% rise in the yen would have reduced the return on the portfolio from $11,130 to a loss of US$6,517 loss or -26% of the US$25,000 invested.
The loss could have been worse because it would probably take a full year to earn the 44.52% profit on the spread between the loan rate and T- Bill return. The foreign exchange loss could come in a matter of months.
If we had assessed our risk on a worst case scenario, we could imagine that just after the portfolio begins, the Mexican peso crashes in foreign exchange markets. We need to consider that the peso suddenly collapsed 15% versus the yen in the first two months after the portfolio started. The portfolio's return from the interest rate spread would be 7.42% (two months' worth of profit at the 44.52% annual rate), but the sudden foreign exchange loss would be 70%. The real loss would be 62.58%.
Most banks would not allow a 70% loss without asking for additional collateral. If extra cash, bonds or securities were not available as extra collateral, most bank would liquidate our position. The loss in the portfolio becomes real, a real whopping US$15,645 of $25,000 invested!
If the yen rose 20% to 86.4 yen per dollar and peso the foreign exchange loss could be the full $25,000. If it rose even more than 20% and if the bank did not liquidate our position, it is even conceivable (though doubtful) that we could have lost the entire US$25,000 and still owed the bank!
We knew there are risks involved in this opportunity that could make 96.72%. We also knew that if we could not afford to lose at least part of our original investment, then we should have avoided this opportunity. We needed to be sure that we understood the risks and could afford to accept them before we used this tactic.
There were ways to reduce some of the risk. One way was to reduce the amount (in percentage terms) that we borrowed.
The risk and reward of this idea were very much affected by the loan to investment ratio of the portfolio. So far we looked only at portfolios with a four to one loan ratio, which is a typical maximum ratio banks allow. However, we could borrow less in relation to the amount we invested. Instead of borrowing four dollars for every dollar we invested, we could borrow three or two or one or really any ratio between four and one. The amount we could borrow is called the loan to investment ratio.
Take for example a projection in which we borrow only three times the amount we invest.
PERFORMANCE PROJECTIONS WITH THREE TIMES LOAN TO INVESTMENT RATIO $75k Mexican Peso Yield 12.00% less 3.87% 8.13% $6,097 Extra Earned From Loan $6,097 $25k Mexican Peso Yield 12.00% $3,000 TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 36.38%% or $9,097
If we had borrowed three times the amount we invested, we greatly reduced our risk of sudden foreign exchange loss. We gave up 8.14% of our potential profit on the rate spread and of course also gave up foreign exchange profit potential too. If the yen fell by 5%, we would have made 14.28% foreign exchange profit (compared to 19.04% if we had borrowed four times the amount invested). A portfolio with a three times loan would earn 50.66% profit with a 5% fall of the yen (versus 63.56% with a four times investment to loan ratio).
A two to one loan ratio would have been even safer and would have even less profit potential as the projection below shows.
PERFORMANCE PROJECTIONS WITH TWO TIMES LOAN TO INVESTMENT RATIO $50k Mexican Peso Yield 12.00% less 3.87% 8.13% $4,065 Extra Earned From Loan $4,065 $25k Mexican Peso Yield 12.00% $3,000 TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 28.26% or $7,065
With a two to one loan ratio, a 5% fall of the yen would add US$2,383 forex profit or 9.53%. The total profit would have been 37.39%.
PERFORMANCE PROJECTIONS WITH ONE TIME LOAN TO INVESTMENT RATIO $25k Mexican Peso Yield 12.00% less 3.87% 8.13% $2,032 Extra Earned From Loan $2,032 $25k Mexican Peso Yield 12.00% $3,000 TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 20.12% or $5,032
The forex profit on a 5% yen fall for a portfolio with a one to one loan ration was $1,119 or 4.47% which meant the total return on this portfolio would have been 24.59% or US$6,127 on US$25,000 invested.
Here were all the profit and loss potentials on three to one, two to one and one to one loan ratios for 5%, 10% and 15% rises and falls of the Japanese yen to the Mexican peso from the assumed parity of 108 yen per U.S. dollar and assuming the U.S. dollar peso rate remained fixed.
3 to 1 2 to 1 1 to 1 Spread Forex Total Spread Forex Total Spread Forex Total 5% yen fall 36.3% 14.1% 50.5% 28.2% 9.5% 37.3% 20.1% 4.4% 24.5% 10% yen fall 36.3% 27.2% 63.5% 28.2% 18.1% 46.3% 20.1% 9.0% 29.1% 15% yen fall 36.3% 39.1% 75.4% 28.2% 26.9% 55.1% 20.1% 13.0% 33.1% 5% yen rise 36.3% -15.7% 20.6% 28.2% -10.5% 17.7% 20.1% -5.2% 14.9% 10% yen rise 36.3% -33.3% 3.0% 28.2% -22.2% 6.0% 20.1% -10.4% 9.7% 15% yen rise 36.3% -52.9% -16.6% 28.2% -35.2% -7.0% 20.1% -17.6% 2.5%
These were our choices available to match the risk to our needs. The four to one loan ratio had 97% profit potential, but could lose all. The one to one ratio offered 33.1% in its upper range but chances of loss were far smaller. Even a 15% yen rise would still have left 2.5% profit over a year.
There were three factors to consider when planning whether to make this investment at all and if so at which investment to loan ratio.
* Factor #1: For how long could we invest? This is not a short term get in and out investment. You must plan to invest for at least a year to let the spread work for you. Unless the yen had taken a sudden dramatic fall at which time you would have wanted to consider taking a quick profit, this was a one to three year investment at the least. It could have taken two or more years for the yen to gradually drift down to a point where we wished to liquidate.
* Factor #2: How was my staying power? The greatest risk in this portfolio was that just after I had started the yen would have a sudden unexpected temporary rise versus the peso. If this happened, could I afford to put up an additional US$12,500 or so per US$25,000 invested as additional collateral?
* Factor #3: How much can I afford to lose? This is a speculation. You could lose all your money. Do not speculate with savings that you cannot afford to lose. Don't use your emergency funds. Don't use the money you have set aside for your kids' college education. Don't mortgage your house in the hopes that you are going to make some great profit. Don't risk your pension.
The more important the need and the sooner the need for that money will be, the lower the loan to investment ratio should have been.
In addition we should have considered how we felt about taking risk. Some investors worry so much about their investments that the stress and strain to their nervous system is not worth any profit they might make. Stress can kill you! Don't jump into any speculation if you are going to worry about it every single day. Put your money in some investment that feels safe to you instead.
This is what I thought that it affected how I invested in December 1993. At that time the yen-dollar parity was 108 yen per dollar. The yen immediately began to weaken and fell to 109 in the first month.
In the next month in terms of Japanese yen, the peso appreciated 3.9%! Those who acted on the data right away really cleaned up in the first couple of months as the peso remained steady to the U.S. dollar, and the yen fell from 108 to 112.7 in January 1994. Thus an investor who invested in Mexican pesos at 15% from yen borrowed at 3.85% made almost 5% in just the first month of this play (1% on the loan rate spread and 3.9% on the yen devaluation).
Then the bottom fell out of this speculation and almost nothing seemed to go right. In fact four of the five things that could go wrong, did. First the peso Cedes 3 month Treasury Bill yields began to drop. Next the peso crashed versus the U.S. dollar. At the same time, the yen recovered and roared upwards in strength to 80 yen per dollar over the next year.
The only factor that did not turn against this speculation was that the interest rate on the borrowed yen did not rise. That rate fell and that factor alone was enough make this speculation look better and better.
Next lesson we will review the investment I made and the risk management procedures that I used to make this speculation safer. There are important lessons here because even though four out five negative events took place, this investment has made money and today looks well placed to create huge profits!
The rules you will learn in the next lesson learn on how to reduce risk and increase profits in synthetic currency speculations can be of great importance to you.
The key to profitability in my speculation was risk reduction and positive carry.
Positive carry means that the investments made from the loan earned more than the cost of the loan. This was important because it meant that the speculation was aimed at making money from the interest rate differential rather than just from the forex difference.
Because the loans in my speculation were in yen, all that has happened from 1993 to 1995 was that the positive carry improved in the portfolio. Originally I borrowed yen at 3.875%, but as this lesson is being written the interest rate has dropped to 2.375%.
All the investments held in the portfolio earned more than 3.875% (and much more than 2.375%). During the entire time that I have held this portfolio, it has made more than it has cost, as long as the foreign exchange difference was not been taken into account.
Since the speculation was of a long term nature, I am being paid to wait until a foreign exchange opportunity presents itself. In this case, I can afford to wait until the yen falls in value (as is dramatically happening in late 1995).
Thus during 1994 and early 1995 the yen rose in value and the portfolio suffered paper losses if the foreign exchange was taken into account. But since the portfolio was maintained through that entire period, this loss did not have to be taken.
After a huge increase in value, the yen has now started to fall dramatically. It has fallen 25% (from 80 yen per dollar to 100 yen per dollar) in the past few months. In short the yen is almost back to the position where it started so there has been little foreign exchange impact at all.
But month after month, even in the worst circumstances, the speculation made money because of the positive carry element in this currency speculation portfolio.
Remember that positive carry means that if your speculation is right in both interest differential and foreign exchange, you make a fortune. If your speculation is right in interest differential but wrong in forex, your positive carry mitigates the error in the foreign exchange analysis.
The most important point is if you cannot gain a positive carry (make more on your investment than the cost of the loan) DO NOT SPECULATE. There will be times (as shown in lesson 13) when you may pay a negative carry (cost) to hedge (which eliminates currency speculation), but none of us should ever speculate when there is a cost to the speculation.
Once you have established this principal about currency speculation, there are many other ways to reduce risk as well. We will look at these risk reduction methods as we continue this case study next lesson.