Yen Carry Trade

YEN CARRY TRADE

A lot has been said, and we have heard even more, about the yen carry trade. We hear about this even more when the markets head south. The meltdown of global stock markets is often attributed to the unwinding of such currency carry trades. And when the unwinding of currency carry trades takes place on a large scale, stock markets all over the world suffer badly. By definition, currency carry trade is a strategy used in the forex markets in which a trader is involved in selling (borrowing) a currency at a lower interest rate and then buying higher interest bearing bonds. And when the bond matures, the trader again converts the currency (at the prevalent exchange rate) to repay his debt. Such trades have an extremely high risk factor because currency exchange rates vary on a daily basis. The yen carry trade is a classic example of a form of arbitrage where investors borrow cheap yen and then invest it in the US Treasury Bills to generate a higher rate of return. The interest rates in Japan (for borrowing) are extremely low compared to other nations. The flowchart illustrates how this strategy works, and how it backfires at times.

There was a time when the yen was considered to be stable currency as compared to the dollar. In 2006, the yen and dollar exchange rates remained almost static. As a result, traders borrowed huge amounts of money in Japan at a relatively lower interest rate to invest in the US. When the time came for the money to be returned, the trader would liquidate his investment in the US and repay the lender in Japan. Since the exchange rates did not fluctuate a lot, the traders managed to capitalize on the gains by investing in higher yielding US based assets. But 2007 presented a different picture as yen remained extremely volatile versus the dollar (See Yen Vs USD). Currency carry trades are for high profile traders and speculators with an extremely high risk appetite. Such trades are not investments; they are merely high-risk high-reward speculation strategies.

Borrow
A trader borrows 2,00,000 Yen in Japan at 0.5% interest rate.
(Final liability - 201000 Yen)

Conversion
This is thenconverted into USD and the trader invests $2000 in US Treasury Bills
yielding 5%. (1 USD = 100 Yen)

Profit
Trader gets $2100 ($2000 plus $100 interest) as proceeds from T-bills on maturity. Interest due to borrower in Japan is 1000 Yen or just $10. So that would be a net profit of $90 on nil personal investment.

The Yen Appreciates
But the scenario changes when Yen appreciates. Say 1 USD = 90 Yen now. The liability in Japan (201000 Yen) is now equivalent to $2233 as against $2010 earlier at the time of borrowing. So the trader needs $223 extra to repay his debt whereas his gains just stood at $100. So the profit is wiped off and the trade results in a net loss. Trader would now need to arrange more dollars to repay debt.

Unwinding of Yen carry trade
As this happens globally and people rush to repay the appreciating Yen, it appreciates further on account of excessive buying (due to conversion). This is called the unwinding of yen carry trade and results in a liquidity crunch as people sell their dollar assets & stocks to repay their debt. This reduces liquidity and consequently affects stock markets