| Yen carry trade | | | | to 0.25% in July 2006 and subsequently increased |
| Yen carry trade - implies borrowing Japanese yen | | | | to 0.5% in February 2007. The rise in interest |
| at low interest rates (0.5%) to finance purchases | | | | rates has increased the borrowing cost of yen |
| of high-yielding assets. The investor earns the | | | | carry traders. This coupled with the recent |
| interest rate spread or "carry" as long as long as | | | | appreciation in the yen has left two exit routes |
| interest rates in Japan do not rise (increases | | | | for traders - book losses by squaring positions or |
| borrowing cost) and exchange rates are stable | | | | hedge the trade using swaps. |
| (exchange rate risk if the yen appreciates). | | | | India and Yen carry trades |
| To briefly explain the process, Japanese yen is | | | | Several funds investing in India have raised money |
| borrowed at very low interest rates. The yen are | | | | from the Japanese market, for example, Fidelity |
| sold to buy a stronger currency. The new | | | | Investments, Deutsche Asset Management and |
| currency can be used to purchase a high-yielding | | | | several others. Japanese money has also entered |
| asset. At the time of unwinding the trade, the | | | | Indian markets through Japanese and other |
| asset is sold to obtain the principal and interest in | | | | investors who are borrowing yen to invest in |
| the underlying currency, which in turn is sold to | | | | Indian asset classes, and corporates borrowing |
| buy yen and repay the yen denominated loan. | | | | yen denominated funds. |
| Such a trade can be hedged at about a 100bp | | | | Excessive speculative funds in the economy, |
| (1%), so if an investor borrows from Japan (@ | | | | caused in part by yen carry trades, have raised |
| 0.5%) and invests in US treasuries at 4.5%, he | | | | the inflation rate to 6.7% and, may lead to |
| clearly earns 300bp (3%). The yen carry trade | | | | overheating of the economy. |
| has been like a continuous money generating | | | | Unwinding of Yen Carry Trades |
| opportunity for big investors. Trillions of dollars are | | | | The recent appreciation in the yen will compel |
| estimated to be in this trade, which has indeed | | | | traders to sell their assets and repay borrowed |
| been profitable for investors. | | | | yen, leading to a fall in asset prices and further |
| Implications of Yen carry trades | | | | strengthening of the yen. |
| Rise in prices of high-yielding assets in which | | | | In October 1998, a mass unwinding of yen carry |
| investments are being made. | | | | trades lead to excessive volatility in financial |
| Weakening of the yen as more and more | | | | markets. During that period the yen had been |
| investors resort to yen carry trades, in turn | | | | depreciating over three years. Mid 1998, the yen |
| making the trades more profitable. | | | | began to appreciate finally leading to a mass selling |
| Increasing risk appetite of investors has seen | | | | of high-yielding assets and underlying currencies to |
| them borrowing yen to invest in emerging | | | | repay yen denominated borrowings. This led to a |
| economies like China and India. Leveraged trades | | | | sharp appreciation in the yen (due to bulk buying |
| further magnify profits as well as risks. At | | | | of yen for repayments) and also led to a steep |
| present the New Zealand dollar and the Australian | | | | fall in high-yielding asset prices (due to bulk selling). |
| dollar are high-yielding currencies, while, the | | | | The Federal Reserve was forced to reduce the |
| Japanese yen and the Swiss franc are the most | | | | fed rate twice to bring liquidity in the markets. |
| popular borrowing currencies, owing to low | | | | Currently, hedge funds have low exposure to |
| interest rates. | | | | forex carry trades as against in 1998, when yen |
| The yen has been weakening against the dollar | | | | carry trade was a very popular strategy for |
| over the past two years. However, recent | | | | hedge funds. Overall, the current quantum of yen |
| appreciation in the yen has seen the unwinding of | | | | carry trades seem lower than those during the |
| yen trades. Also, the unexpected 4.8% growth in | | | | 1998 period, even then, a possible future mass |
| the Japanese economy in the fourth quarter of | | | | unwinding of yen carry trades would most |
| 2006 will force the country's central bank to raise | | | | definitely create volatility in the markets. For an |
| rates. Japan's short-term interest rate was 0% | | | | Indian investor, this is just one of the unexpected |
| from 2001 till July 2006. This rate was increased | | | | effects of increasing globalisation! |