Recently we reviewed how there are three ways to really make money. Organize, Innovate or take risks. Here I share one risk taking tactic that really can earn 72.92%or more in the next year. Learn below why the potential and what is the risk.
Right now there are many fundamentals that suggest currency turmoil. In such economic conditions countries with potentially weak currencies have to pay higher rates, such as in Mexico. Because Mexico is having difficult economic times as well as the U.S., many investors feel Mexico may devalue the peso. If you disagree or feel the peso will not fall much, here is a way to maximize the 18.23% interest the Mexican government is paying on three month government bonds.
Here is an investment that can take advantage of this current currency turmoil.
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 10% T-BILL RETURN
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
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 8% T-Bill Return
$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.
How You Chose the Ratio
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.
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 was 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 finally fell dramatically. It fell from 80 yen per dollar to 146 yen per dollar) at which time I recommended to me readers to take the forex profit.
Though this was an immensely profitable speculation at times, on paper, it looked like disaster! But month after month, even in the worst circumstances, the speculation made money because of the positive carry element in this currency speculation portfolio. The position turned out right because I believed in the fundamentals, had completed my homework so I knew how much I could risk and what the risks were and consequently held my position when the investment looked bad.
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 at our upcoming International Investment & Business Course in Vancouver April, 25 to 28. I hope to see you there!