A strategy in which an investor sells a certain currency with a relatively low-interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates – which can often be substantial, depending on the amount of leverage the investor chooses to use.
How Yen Carry Trading Works?
Suppose an investor wants to take advantage of the low-interest rates in Japan to earn a higher return on their money. The investor could borrow 1,000,000 Japanese yen at an interest rate of 0.5% per year and use the proceeds to buy US dollars.
The investor then uses the US dollars to buy a bond yielding 5% per year. The investor earns a net return of 4.5% per year on the investment (5% yield minus 0.5% borrowing cost).
If the investor holds the bond for one year and the exchange rate between the yen and the US dollar remains the same, the investor would earn a profit of 45,000 yen (4.5% of 1,000,000 yen). The investor would then pay back the 1,000,000 yen loan, closing out the trade.
The yen carry trade was a popular investment strategy that involved borrowing the Japanese yen at low-interest rates and using the proceeds to buy higher-yielding assets in other countries. This strategy was attractive to investors because Japan had a long period of low-interest rates, which made it relatively cheap to borrow the yen.
Yen Carry Trade Vs Subprime Crisis
During the subprime mortgage crisis, the yen carry trade was one of the factors that contributed to the global financial turmoil. The crisis began in 2007 when the housing market in the United States collapsed, leading to a wave of defaults on subprime mortgages. This caused a credit crunch and a drop in asset prices, including stocks and real estate.
As investors around the world rushed to sell assets and reduce their risk exposure, the demand for safe-haven currencies like the Japanese yen increased. This led to a rapid appreciation of the yen, which made it more expensive for investors to borrow yen for the carry trade.
As a result, many investors who had been using the yen carry trade were forced to unwind their positions, selling their higher-yielding assets and repaying their yen loans. This contributed to the sell-off in global financial markets and further exacerbated the financial crisis.
Overall, the yen carry trade and its unwinding during the subprime mortgage crisis played a significant role in the global financial turmoil of the late 2000s. The experience of the crisis highlighted the risks associated with relying on low-interest borrowing to finance investments and the importance of diversifying risk in investment portfolios.