October 6, 2009

What Is Yen Carry Trade?

Yen carry trade is a form of currency carry trade using the Japanese yen. Carry trade is an investment strategy in which an investor borrows (buys) a currency with a low interest rate and lends (sells) a currency with a high interest rate. In this way they can make money on the difference between the interest rates.

This type of investment is popular with banks, governments and other large lending institutions, especially at times when the the global currency markets are relatively stable and the global stock markets are broadly bullish. In other words, it can be a good investment strategy at times of world economic stability and growth.

The Japanese yen is a the currency most frequently involved in carry trade. This is because over the past years it has consistently been the major currency with the lowest interest rate. The Bank of Japan, which controls Japanese interest rates, has set them at a very low level since the late 1980s. Often this is under 0.5%.

Theoretically you would not expect carry trade to be profitable because the currency values would change to reflect the difference in interest rates and this would balance out the possible profits. However, in practice there is a profit potential because carry trades have the effect of weakening the borrowed currency. So yen carry trade keeps the yen artificially weakened.

Of course there is a risk that the tide will turn but due to the level of control exerted by the Bank of Japan, international confidence is generally quite buoyant. However, in the case of a major financial crisis in the USA and the other main economic powers the yield of carry trade is bound to fall.

Indeed where there is a big change in currency values such that the yen rises in value against the lent currencies, it is possible for the investors to lose money when it comes to reversing the investment. Since there is a huge amount of money invested in yen carry trade it can have a significant destabilizing effect on the currency markets if institutions suddenly turn away from this form of investment.

This effect is known as the unwinding of yen carry trade. It happens when investors become averse to risk which is likely to happen when the yen is strengthening against the lent currencies. This can have a significant effect on the value of yen currency pairs. As we saw, yen carry trade weakens the yen so the effect of the unwinding will be to strengthen the yen side of the pair even further.

Yen carry trade is for the big players in the international money markets. It is not something that a home based forex trader would usually expect to get involved in directly. However, any forex trader involved in a yen pair needs to understand yen carry trade and its effect on yen prices.

What Is Yen Carry Trade?

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