Carry Trade

One of the most modish methods today, is the Carry trade technique. This technique, mainly used by institutional investors, but also by a lot of private investors, consists of taking advantage of the yield gap between asset classes.

This intervention method consists in getting into debt in a currency with a low interest rate and in investing the borrowed funds into another currency with a stronger interest rate. Thanks to this system, the investors take advantage of the interest rate differential.

The Carry Trade positions are generally taken on the Yen (JPY). In fact, the key interest rate of the Bank of Japan (BOJ) is now very low (0.5%), so the investors massively sell yen in order to take advantage of the interest rate differential between the currencies. The main currencies that enjoy this trading system are in particular the US dollar, which enjoys a 5.25% key interest rate, the Euro, which enjoys a 4% key interest rate, and the Sterling Pound, which enjoys a 5.50% key interest rate (figures from June 2007). These key interest rates have an influence on the daily interest rates used for the swap operations.

Currently the Bank of Japan (BOJ) intervenes on the exchange market by selling important amounts of yen in order to keep a devalued yen that enables the exporting Japanese firms to stay competitive. On the other hand, the low interest rates put in place by the Monetary Committee of the Bank of Japan participate in the development of the firms, which so can get into debt with least cost.

In the XXI century, when the internet bubble exploded, most of the States in the world lowered their key interest rates in order to prevent the amplification of the crisis. However, to the contrary of most of the States which since then increased their key interest rates, the Bank of Japan, with an important growth beneficial, a decrease of unemployment and no real inflation tension (deflation period), didn’t think it was necessary to strongly increase its key interest rate.

This policy run by the Bank of Japan enables the investors to take advantage of the interest rate differential between the Japanese currency and other currencies like the Euro, the US Dollar and the Pound Sterling…. So the investors who use the Carry trade technique are closely watching the decisions of the Japanese monetary committee.

The Carry Trade technique, which can be very lucrative, in particular nowadays thanks to the devaluation of the yen, includes an important risk. In fact, an evaluation of the Japanese currency would cause a Carry trade closing out by a large part of the investors because these positions would not be interesting any more as the gain obtained on the interest rate differential would not be strong enough to cover the valuation of the yen.

It is to notice that the Carry trade positions lead to an important devaluation of the Asian currency because of the huge amounts of transactions done thanks to the trading system, so the method is even more interesting….

In 1998, the system partly exploded. In fact, in two days, the American dollar nearly lost 20 figures (2000 pips). This important devaluation of the US dollar brought out serious consequences for a lot of investors, in particular the speculative funds LTCM which avoided bankruptcy thanks to the Fed’s intervention.

By the end of 2006, the bank Barclays Capital estimated the Carry trade speculative net positions at more than $30 billion. The Japanese deputy minister for finance, Hiroshi Watanabe, talked about amounts between $80 and 160 billion.

As long as the yen remains weak, the system lasts, but the closing at the same time of Carry trade positions following for example an important change of the Japanese monetary policy could have a serious impact on the international financial system.