Yen carry trade

Yen carry trade – implies borrowing Japanese yen at low interest rates (0.5%) to finance purchases of high-yielding assets. The investor earns the interest rate spread or “carry” as long as long as interest rates in Japan do not rise (increases borrowing cost) and exchange rates are stable (exchange rate risk if the yen appreciates).

To briefly explain the process, Japanese yen is borrowed at very low interest rates. The yen are sold to buy a stronger currency. The new currency can be used to purchase a high-yielding asset. At the time of unwinding the trade, the asset is sold to obtain the principal and interest in the underlying currency, which in turn is sold to buy yen and repay the yen denominated loan.

Such a trade can be hedged at about a 100bp (1%), so if an investor borrows from Japan (@ 0.5%) and invests in US treasuries at 4.5%, he clearly earns 300bp (3%). The yen carry trade has been like a continuous money generating opportunity for big investors. Trillions of dollars are estimated to be in this trade, which has indeed been profitable for investors.

Implications of Yen carry trades

Rise in prices of high-yielding assets in which investments are being made.

Weakening of the yen as more and more investors resort to yen carry trades, in turn making the trades more profitable.

Increasing risk appetite of investors has seen them borrowing yen to invest in emerging economies like China and India. Leveraged trades further magnify profits as well as risks. At present the New Zealand dollar and the Australian dollar are high-yielding currencies, while, the Japanese yen and the Swiss franc are the most popular borrowing currencies, owing to low interest rates.

The yen has been weakening against the dollar over the past two years. However, recent appreciation in the yen has seen the unwinding of yen trades. Also, the unexpected 4.8% growth in the Japanese economy in the fourth quarter of 2006 will force the country’s central bank to raise rates. Japan’s short-term interest rate was 0% from 2001 till July 2006. This rate was increased to 0.25% in July 2006 and subsequently increased to 0.5% in February 2007. The rise in interest rates has increased the borrowing cost of yen carry traders. This coupled with the recent appreciation in the yen has left two exit routes for traders – book losses by squaring positions or hedge the trade using swaps.

India and Yen carry trades

Several funds investing in India have raised money from the Japanese market, for example, Fidelity Investments, Deutsche Asset Management and several others. Japanese money has also entered Indian markets through Japanese and other investors who are borrowing yen to invest in Indian asset classes, and corporates borrowing yen denominated funds.

Excessive speculative funds in the economy, caused in part by yen carry trades, have raised the inflation rate to 6.7% and, may lead to overheating of the economy.

Unwinding of Yen Carry Trades

The recent appreciation in the yen will compel traders to sell their assets and repay borrowed yen, leading to a fall in asset prices and further strengthening of the yen.

In October 1998, a mass unwinding of yen carry trades lead to excessive volatility in financial markets. During that period the yen had been depreciating over three years. Mid 1998, the yen began to appreciate finally leading to a mass selling of high-yielding assets and underlying currencies to repay yen denominated borrowings. This led to a sharp appreciation in the yen (due to bulk buying of yen for repayments) and also led to a steep fall in high-yielding asset prices (due to bulk selling). The Federal Reserve was forced to reduce the fed rate twice to bring liquidity in the markets.

Currently, hedge funds have low exposure to forex carry trades as against in 1998, when yen carry trade was a very popular strategy for hedge funds. Overall, the current quantum of yen carry trades seem lower than those during the 1998 period, even then, a possible future mass unwinding of yen carry trades would most definitely create volatility in the markets. For an Indian investor, this is just one of the unexpected effects of increasing globalisation!



Source by Fatima Jiwani