Yen Carry Trade Explained: Pros, Cons, How It Is Today

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The carry trade is when investors borrow in a currency with low interest rates and invest in a currency that pays high rates. Photo: Artifacts Images/Photodisc/Getty Images

Definition: The yen carry trade is when investors borrow yen at a low interest rate. They exchange it for U.S. dollars or any currency in a country that pays a high interest rate on its bonds. They receive a low-risk profit when they receive high interest on the money invested, but pay low interest on the money borrowed. The broker pays the difference into the account each day the trade is open.

Advantages

That works great as long as the currencies remain stable.

It works even better when the currency in the high-interest rate country appreciates. That means the forex traders earn more profit when they exchange their dollars back into yen. That's because they need fewer dollars to buy the same amount of yen.

If enough investors do this, it boosts demand for the high-interest-rate bonds. The investors can sell these bonds at a profit on the secondary market. That can happen because the foreign exchange market is the largest in the world. It trades $5.3 trillion a day.

As demand for the high-interest-rate bonds increases so does demand for the currency. It boosts the value of the currency, creating further profit for holders of the higher yielding bond. (Source: "Carry Trade Definition," Financial Times)

Disadvantages

Traders get into big trouble if the value of the yen increases or the value of the dollar declines. That means they've got to come up with more dollars to pay back the yen they've borrowed.

If the difference is enough, they could go bankrupt.

Traders also get into trouble if the currency values change a lot during the year. That's because they've got to maintain a minimum in the brokerage account. If the currency changes a lot, and the trader doesn't have enough extra cash to maintain the minimum, the broker could close the account.

If that happened, the trader could lose his entire investment.

Yen Carry Trade Today

The yen carry trade is alive and well in 2015, but not with the U.S. dollar. That ended in 2008 when the Federal Reserve dropped the Fed funds rate to near zero. It continued with high-yield currencies such as the Brazilian real, Australian dollar, and Turkish lira. For example, many forex traders borrow near-zero yen to buy Australian dollars which have a 4.5% return.

Trading in the yen began to pick up in October 2012 when Shinzo Abe was elected as Prime Minister. He promised to boost economic growth by increasing government spending, lowering interest rates, and opening up trade. He accomplished the first two but had less progress on the third. Between 2010 and April 2013, the yen carry trade rose by 70%.  As a result, the yen expanded its share of global forex trading to 23% of the total in 2013. 

However, when Abe raised consumption taxes in 2013, Japan's economy went back into recession. The Bank of Japan responded with more Quantitative Easing, sending the yen to a 7-year low in October 2014. The yen remained at those levels in 2015. For more, see U.S. Dollar Rate. (Source: Boby Michael, "Yen Plummets to 7-Year Low on BOJ Easing," International Business Times, October 31, 2014)

How Does the Yen Carry Trade Affect the U.S. Economy?

Many experts believe that the global liquidity before the 2008 financial crisis was thanks to the carry trade in yen, which had close to a zero interest rate cost.

The monetary stimulus in Japan is aimed to produce a cheaper yen, and thus a stronger dollar. That causes the U.S. bond market to rise, bond yields to decline, commodity prices to plunge, and precious metals prices to fall. If you are in any of these investments, you must know what drives their prices.