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An explanation of the carry trade

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Those of you watching recent events in the financial markets might have seen the terms ‘carry trade’, ‘Yen carry trade’ and ‘YCT’ crop up a few times. This is often explained in the press as the process of borrowing money in a low-interest currency and investing it in high-interest one. Which is true, but there’s rather more to it than that and we have to step back a few years to find the full explanation.

About 20 years ago Japan went through a period of property price inflation, a speculative bubble of investment driven by people who assumed that property prices only went up, particularly on a crowded island where there was little scope to build new homes (sound familiar?). Inevitably, as always happens when prices exceed underlying fundamentals for a length of time, the Japanese property market crashed, hard. I’ve read figures quoting a 40-45% drop since the early 1990s, much of that happening in the first few years.

As is the standard reaction to such an event, the Bank of Japan dropped their interest rates. And dropped them. And dropped them again. Doing so was intended to encourage people to borrow money to stimulate economic growth. But the Japanese had had their fingers burned once through borrowing and, perhaps partly for cultural reasons, were extremely reticent to do so again. The Bank of Japan, to use a popular phrase, was ‘pushing on a string’ in trying to encourage Japanese people to borrow.

However, with laws around the world being relaxed to allow more free movement of capital between countries and currencies, the Yen had quite a few takers outside of Japan. Foreign investment bankers and fund managers saw opportunities in borrowing large quantities of Yen at low interest rates and ploughing them into countries where the currency yield was much greater. For example, even today you can borrow Yen at 0.5% interest per year and invest it in the UK at 5.75% interest. And that’s without using your borrowed Yen to invest in riskier, potentially higher-return foreign investments such as shares, commodities and, dare I say it, property.

The Yen wasn’t the only currency to be used in a carry trade. Any currency pair was fair game where a lower yield could be borrowed and then lent for a higher yield. These included the Swiss Franc against the Euro or the Pound, the Euro against the Turkish Lira and many others. The greater the difference in yield, the greater the interest earned, but the greater the perceived risk.

At some point, of course, the loans would have to be repaid in Yen. But the great thing about the carry trade was that the more people who got involved, the weaker the Yen became against other currencies. So when you eventually repaid your loan in Yen, you could do so at a cheaper exchange rate than you had borrowed it. Fantastic! You borrow money to earn interest on that money, then pay back less in real terms than you had borrowed in the first place.

Soon even individual investors were getting in on the carry trade, through online currency trading accounts. Apparently it has been particularly popular amongst Japanese housewives. But, as is usually the case when someone tells you that an investment can only go up in value, this situation couldn’t last forever.

It’s important to bear in mind that most of this borrowing was leveraged, which means that any movements in exchange rates were multiplied. For example, with a leveraged account at 100-to-1, you might use £10,000 to borrow £1,000,000-worth of Yen. So you get the interest on £1,000,000 even though you’ve only invested £10,000. However, a 1% negative move in the exchange rate would wipe out your entire £10,000 stake and you’d have to repay your loan. This is known as a margin call, another phrase you might have heard recently, perhaps in a sentence such as “Hedge fund forced to liquidate assets at a loss due to margin calls”, though the hedge funds were dealing with stakes of hundreds of millions or even billions of dollars.

Anyway, the only danger, as these investors saw it, was that the Japanese economy could suddenly get stronger, resulting in the Bank of Japan pushing up interest rates to counter inflation and the value of the Yen rising against other currencies. But Japan has been hovering around the low growth / zero growth / negative growth point for years and the Bank has been pretty good at signalling its intentions well in advance, arguably helped by political will to keep the Yen artificially cheap to assist its export industry.

Of course, there are two sides to any currency trade. You may borrow in Yen, but in doing so you are also investing in US dollars, or Pounds Sterling, or Icelandic Krona, or Turkish Lira, or whatever other high-yielding (i.e. high interest) currency you may choose. The Yen doesn’t have to get stronger on its own for you to be in trouble: the other currency could get weaker, making the Yen stronger by comparison. But in the Western countries with their good old stable economies, that didn’t seem likely.

In the end, in summer 2007, what happened was much, much bigger than most people had anticipated and not directly related to the value of the Yen, at least not initially. Some of the borrowed money ended up in rather complex investment instruments based on residential mortgages. Many of those were in the USA. Some of the people who took out mortgages turned out to be… well, less than 100% likely to be able to afford them. Suddenly a lot of investment banks and funds were losing money.

Margin calls were hit. Loans had to be repaid, some of them in Yen. Which meant that the Yen suddenly gained in price against other currencies. Which in turn made it more expensive for other banks and funds to repay their loans in Yen. Which led to more margin calls, more fast liquidations and so on, in a vicious cycle, a disorderly unwinding of the carry trade.

Sentiment changed. People began liquidating their Yen positions even if they were nowhere near a margin call, because they believed that the Yen would continue to appreciate and that they might end up losing their initial stake (after all, it’s better to quit now than run the risk of greater losses in the near future). This became a self-fulfilling prophecy, and *all* the carry trades suffered, some by more than ten percent in the space of a few weeks (equating to a 1,000-fold movement at a leverage of 100-to-1, remember).

The carry trade isn’t dead yet. Interest rates in the various currencies are pretty much the same as they were before all the unwinding started and some investors are still involved. But the fear of risk is so great that few large funds and banks are willing to play it, even if they have the funds to do so, at least until they know how the next few months will play out.

  1. dr. filthy says:

    Thanks economonkey…. you rock. Very good articles, clearly written in a way that even a filthy “thick as bricks” kinda dood like me could understand.

    I hope you keep writing, you’re very talented!

    Cheers,

  2. Jeff Benson says:

    Please explain from an economic standpoint why the target currency is devalued in the YCT. My confusion comes from the assumption that increased borrowing (of the target currency) is essentially increased demand and reduction of supply by moving the currency out of the country.

  3. Thanks for your comment. With the YCT, effectively you are selling the Yen to buy higher-yielding currencies, which you then put in bank accounts or other investments. If everyone’s selling, the price goes down.

    What we’re seeing now is the Yen (and other carry trade recipients) appreciating because investors are having to buy Yen to repay their loans.

  4. Sorry, by ‘recipients’ above I meant ‘currencies’.

  5. How much you recommend to leverage to use carry trade.

    Some forex accounts offer 200:1 but based on my knowledge most professional investment banks wont even do 5:1

    I used to be invested in a Forex Fund that was leverage 3:1

    I like to play around 4:1 do you think it is satisfactory

    Nice Writeup

  6. Charles says:

    How can an individual investor borrow in yen?

  7. Thanks for the article Alex, it was very well written. I am not clear on your response to Jeff’s question about the effect of the carry trade on the value of the target currency. It seems that in the carry trade practice, the amount borrowed in the target currency is equal to the amount sold in the target currency in the purchase another currency (or other asset). In this case, wouldn’t the value of the currency be fixed because there is an equal amount of buying and selling?

  8. @Furu: money management matters more than leverage. Is it better to leverage 10:1 with £1,000 or leverage 100:1 with £100? Either way a fairly small move would wipe you out. Whatever you do, start small. Currency swings can be huge. As always, only invest what you can afford to lose.

    @Charles: you could set up a currency trading account and ’short’ the Yen against other currencies that way. If you actually wanted Yen in your hand (or bank account) to invest elsewhere, though, I don’t know how you’d do that. Easy enough for a commercial investor, probably rather more difficult for a retail investor.

    @Frank: good point, and in all honesty I’m not sure. It’s certainly the way things have been (until the middle of last year when the carry trade started to go ‘twang’). It might have something to do with the relative ‘velocities’ of the borrowed money (from your broker) versus the sold money (on the open market). When I have time I’ll look into this some more, unless anyone else would like to chip in here?

  9. Hot Topics - Finance « SGSITS eLearning says:

    […] Carry trade […]

  10. Dear Alex:

    Thanks for your explanation in understanding the carry trade.

    Frank’s question is a good one but I think it’s important to understand the role between the Private Bank “PB”, and the Government’s Central Bank”CB” as well as the role of the investor and the overall market.

    For example, if an investor borrows the target currency from PB, he is effectively causing the PB to ask the CB to issue more of the target currency (Thus, PB is effectively borrowing from CB in order to lend to investor. CB is the ultimate issuer of the target currency and therefore CB is increasing the money supply). I believe basic economics would suggest this will dilute the target currency, since there is more supply out there and also correspondingly less demand (since more people are selling the target currency than are buying). Likewise, if investor now decides to pay back this loan, he now has to go out and find yen creating greater demand without a corresponding increase in the supply of the target currency. Also, this will eventually reduce the supply of the target currency when PB pays CB and removes it from the currency system possibly causing a further increase in the target currency.

  11. Useful stuff, thanks daveJ. Is this an increase in M4 for the currency concerned? I’m still finding some of the Mx figures bizarre, even with the recent BoE clarification.

  12. Deflation or inflation - what will happen in the UK? | economonkey says:

    We can look to Japan for some hints (its property bubble burst in the early 1990s, since when it’s stumbled on with a deflationary home economy, exporting inflation to other countries via the carry trade through its low interest rates), but things are rather different here, as the UK is a nation of spenders rather than savers and will, on past experience, take on any and all debt offered.