The Yen Carry Trade: The Impact of Rising Japanese Rates

One of the most significant trades that exist today is the carry trade on the Japanese yen. A basic description of the yen carry trade is that traders borrow yen in Japan at low interest rates, convert the yen into another currency, and invest the funds at a higher interest rate. The trader then earns the interest rate spread between the two currencies, but bears the risk that the yen will appreciate before the loan is repaid.

Though the risk from currency fluctuation is significant in relation to the interest rate spread, over time the interest spread earned on a carry trade can also be significant. While textbook carry trades involve risk free interest bearing assets, there is no reason why traders can't use the borrowed yen to purchase other financial assets such as U.S. or European equities and corporate bonds. For many years Japan has been a major source of cheap leverage for international financial markets.

The derivatives instruments available today have enabled traders to synthetically create carry trades without engaging in loans with Japanese banks or handling actual yen currency. This has increased the ease with which traders can access this carry trade and has increased its magnitude and importance.

The global financial markets have become so integrated that individual central banks and governments no longer have control over their own financial markets. When a central bank raises interest rates to cool their financial markets some traders will simply access leverage through an alternative currency at cheaper rates. This can curb the impact that central bank interest rate hikes may have on local markets.

It is impossible to measure the total size of the yen carry trade, but it is clear that it is absolutely massive. This fact highlights the concern of what will happen if the Bank of Japan raises interest rates significantly. The Bank of Japan has been threatening to raise rates for years, but many see it as "crying wolf".

If the Bank of Japan actually did significantly raise interest rates it could undermine the cheap leverage that has been available for so many years. The unraveling of these trades could no doubt have a remarkable impact on global financial markets. First, the yen could rally as traders are forced to purchase the currency and repay the yen based loans. Second, the proceeds used to purchase the yen would likely come from the sale of assets previously bought with yen based leverage.

Gone are the days when national economies could be examined in isolation. International financial markets have evolved into a single global economy and it is important to watch the Bank of Japan in addition to the local central bank.

Disclaimer:
The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Please carefully consider your financial condition prior to making any investments. MF Global Canada Co. is a Member CIPF.

Article Source: http://www.find-investment-advice.com

Aaron Fennell is an account executive at the Toronto branch of MF Global. He has been actively trading since February 2002 in the areas of futures, options on futures, securities, and security options. If you would like to learn more about the yen carry trade contact Aaron Fennell via the MFGlobal website.

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