Please Answer This Fundamental Question Re Carry

I have been having a discussion with my father re these questions, and can someone please clarify the answers for me:
Consider the usd/jpy. If one buys 1 lot or $100000 of usd, and the current rate for the base currency is 120 yen, the he will exchange 12000000 yen for
$100000. He will have bought the usd and sold the yen. He will be charged a carry rate, he will pay interest on the 12000000 yen and receive interest on the usd, differential is called the swap. Right so far? Now why does he have to pay interest on the currency sold, the yen, and why does he receive interest on the usd?

Now, assume the usd rises to 150 yen. When you sell the usd and buy the yen to unwind this transaction you convert 12000000 into $, right?
but if you convert back to $ you will lose money on the transaction, because the $ rose in value?

thanks,

Liz

Its easier to think of in terms of debt/equity. When you short usd/jpy you are in effect going into debt with a Japanese bank (borrowing Yen). As with any debt your obligated to pay the prevaling interest rate to cover the lenders risk.

Now you have this big pile of yen and it isn't doing you any good, so you convert it into USD and loan it to your broker. Because your broker is now in debt to you he is obligated to pay YOU interest. If your borrowing costs are lower then your lending rate, you collect the spread.

Technically you don't really pay interest to a japanese bank nor do you lend money to your broker. Another trader or other liquidity provider is taking the opposite side of the transaction and you guys are collecting from/paying each other but that makes the discussion too complicated...

No you are currently long dollars, so you will convert your $100k into 15m yen. Once you pay back your 12m yen loan it will leave you with net 3m yen. The math goes something like:

.....100k USD X 150 yen per $ = 15m yen - 12m yen loan = 3m yen net

You can then convert that 3m BACK to dollars ($20k usd) and withdraw it from your account. This is all on top of the interest spread you made.


Hope that helps.