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Synthetic Dollar Lending with Yen Bonds and FX Forwards

Article Quant Q&A · Author: tweedi
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Summary

The document describes a trade that starts with dollar funding, converts it to yen through a one-year FX forward arrangement, invests in a Japanese government bond, and later uses the bond proceeds to settle the currency exchange. It examines whether the bond and forward legs together can provide dollar lending exposure at a yield related to the difference between dollar and yen rates.

One example reports a profit on the initial funding that is close to the stated difference between one-year overnight indexed swap rates. A second historical example produces a lower yield than the dollar rate, leading the author to question what drives the profit and whether it represents arbitrage. The examples motivate the question but do not resolve it. The document also notes that the bond is held at historical cost, with only purchase-cost FX revaluation included, so its accounting treatment affects how the reported profit is presented.

Key ideas

  • The proposed trade combines dollar funding, a yen investment, and a forward exchange back into dollars.
  • The author compares reported returns with the difference between dollar and yen overnight indexed swap rates.
  • A second example does not match the first example’s apparent yield relationship.
  • The document raises questions about the trade’s profit drivers without providing a definitive explanation.

Tags

ForexFixed incomeArbitrageCarry
Full text
# Lend $ synthetically at higher yield using ¥: it works but why?


# Lend $ synthetically at higher yield using ¥: it works but why?












The Trade is:

- You have USD 100m funding

- Swap USD for YEN equivalent at today's spot, agree to swap back in 12 months at the USD/JPY forward rate

- With the YEN buy a 12 months Japanese Government bond

- In 12 months, the JGB matures, get the YEN proceeds from the principal repayment, give the YEN back to the FX swap counterparty, get us your USD back.

Here is a numerical example of a practical implementation. The deal is price each month for 12 month until it unwinds:

As you can see in col V the swap makes USD 12 million, the FX revaluation of the bond (which is held at historical cost, so no MtM for the bond in this deal apart from the FX revaluation of the purchase cost) makes USD -7.4m, and the total is a profit of USD 4.9m. This is a yield of 4.9% on the initial $100m of funding we had. In the meantime when the trade was placed, USD 1y OIS was at 5.4% and YEN 1y OIS was at 0.52%. So the yield differential was at 4.88%. Very close to the 4.91% obtained. For full disclosure I am using JYSO Index and USSO Index for the OIS rates.

This led me to believe that by doing this arbitrage and holding to maturity, one can simply use the bond as a hedge for FX risk, and capture what seems to be the yield in the FX swap cash flows.

However here is another deal at a later time in history, and as you see the logic is broken:

Now this trade yield 1.61%, whilst I could have lent $ at 0.47% for a yield and borrowed yen at -0.14%. The numbers don't add up anymore.

What is happening here? Sometimes this lets lend USD at higher rate than the US rate, and sometimes at a lower rate. What is the PnL of this trade actually capturing?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.