4mins read
Published on: Aug 21, 2024
#Financial Markets
Yen carry trade is a trading strategy in the forex market that involves borrowing a low interest yen and then trading with a high interest USD.
• In Japan, the annual benchmark interest rates ranged from -0.1% to 0.1%. As for the U.S., it stood at around 4%.
• The forex market borrowed a lot from Japan and invested in the U.S. bonds during the past years, profiting off the difference in interest rates in the two countries.
• Recent decisions from the Japanese central bank have upset such trading trends.
As per a recent Bloomberg report, Japanese retail investors are flocking back into high-yielding currencies such as the Mexican peso and Turkish lira amid signs the yen’s surge is coming to a halt. Traders are taking net short positions in the yen against the peso and lira at levels last seen on 2nd August.
• The disruption these past few weeks was caused by a decision of the Bank of Japan (BoJ) to raise its annual benchmark interest rate to 0.25% from the previous range of 0%-0.1% on July 31st.
• The BoJ had earlier raised interest rates from -0.1% to the range of 0%-0.1% in March.
• It is the first year since 2007 that the Japanese central bank has hiked interest rates.
It is worth noting that 2007 was the beginning of the global financial crisis (GFC) and the low rates were meant to stimulate economic activity during the following years.
Japanese retail investors had poured into carry trades involving borrowing yen to buy higher-yielding currencies and make extraordinary profits. The yen, Japan’s national currency, emerged as the best currency for carry trades during these years. The recovery suggests that traders have been somewhat able to heal from their losses.
To understand what’s happening, we must learn about the yen carry trade in detail.
Simply put, the Yen carry trade is a kind of currency carry trade. A currency carry trade is a trading strategy in the forex market that involves borrowing a low-interest currency and then trading with a high-interest currency. So, how does it work?
Suppose you decide to try yen carry trades.
• First, you borrow yen at low interest rates. The interest rate in Japan for these past years was almost zero, ranging from –0.1% to 0.1%.
• Next, you convert the borrowed yen into a high-interest rate currency such as the U.S. Dollar at the current exchange rate.
• Then, you invest in high-yielding assets such as government or corporate bonds with the converted USD. The annual interest rate on bonds in the U.S. is around 4%.
• Once the investment period is over, you gain a higher interest rate on the bonds and pay a lower interest rate on the borrowed yen.
• The difference between the two interest rates is your realised profit from the carry trade.
The interest rates in Japan and the U.S. during the past few years stood at 0.1% and 4% respectively.
• Let's say you borrowed 26 million yen in January 2023.
• Then you converted 26 million yen into USD at the exchange rate of 130 yen per dollar. You got $200K after the exchange.
(¥26 million equaled to $200,000 as per the exchange rate then.)
• Next, you invested the amount of $200K into a government bond which offered an annual interest rate of 4%.
• After a year of investment, you received $208K in January 2024.
($200,000 + $200,000 x 0.04 = $200,000 + $8,000 = $208,000)
• Remember that you were required to pay off your debt of ¥26 million at an annual rate of 0.1%.
• So, you had to return ¥26.26 million in Japan 2024.
(¥26 million + ¥26 million x 0.01 = ¥26 million + ¥260,000 = ¥26,260,000)
• You owned $208,000 out of which you had to return the borrowed amount of ¥26.26 million.
• Let’s convert the return in USD into yen.
$208K equaled ¥27.04 million, assuming the exchange remained the same a year later.
• Once you returned ¥26.26 million, you were left with ¥780K.
(¥27.04 million – ¥26.26 million = ¥780K)
¥780K equaled $6,000.
So, you essentially made a profit of $6K over a year due to the difference in interest rates of the two currencies. This is exactly what was happening in Japan for the last few years until the BoJ decided to hike interest rates, fueling a global stock market crash.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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