The yen carry trade is one of the most celebrated kinds of arbitrage trade.
The carry trade is based on stable return hopes from high yielding currency.
So what is a carry trade?
The point is, can we consider it a viable strategy at the moment?
For that, let’s try and understand the basis of this strategy?
Carry trade is based on taking advantage of the difference in currency rates.
The currency market is one of the most dynamic ones.
One or the other currency is trading.
Some are trading at higher rates while others are at a discount.
Carry trade is simply taking advantage of this price variation.
The question is how you can make it work in your favor?
Well, that clearly depends on the amount of leverage.
But first of all, it is important to understand the concept properly.
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Definition of Yen Carry Trade
Different countries have different rates of interest.
Now the exchange rate is often the outcome of the varying interest rate.
An astute trader makes a profit from the difference in the rates.
The reason why traders choose this is primarily the extent of gains.
In fact, it can be significantly huge, if you can peg it well.
The exchange rate is the key determinant of gains.
Even the smallest movement in the overall rate can lead to a huge difference.
The uncertainty of exchange rates is a major concern.
The rate of leverage too is crucial.
Carry trade can be successful between any two currencies.
But the question is, why choose Yen?
One of the reasons is surely the size of the Japanese economy.
Moreover, Japan has extensive trade with the United States.
The dollar is one of the world’s most used currencies.
In fact, it is used as a benchmark in many international transactions.
Moreover, the consistently low-interest rates in Japan is a big catalyst.
This has made the yen-dollar pair a popular carry trade alternative.
The Yen’s Trade Potential
There is another reason why the yen carry trade is a popular trade.
This is because the yen is a very heavily traded currency across Asia.
Despite the size of the Japanese economy, it has an extensive use.
In fact, around the 1980s, pundits believed that it would join the dollar as a benchmark.
However, the economic downtrend in Japan became a roadblock.
But the yen continues to be one of the world’s most important currencies.
Japan’s continued weakness led to low-interest rates.
The Japanese central bank was forced to keep them below average expectations.
But for traders, this was a golden profit-making opportunity.
The policy makers kept the rates low to revive the economy.
But, the traders used this opportunity for profitable yen carry trade.
The speculators and traders sold yen to get higher proceeds.
They used it then to buy other high yielding currencies.
As a result, the yen rate continues to remain lower.
The regular selling does not allow prices to rise too much either.
Selling yen, therefore, became a popular carry trade strategy.
However, the success of yen carry trade is closely linked to global markets.
The level of financial stability and the volatility are key factors.
The popularity of the carry trade is directly proportional to the volatility.
This is a kind of trade that flourishes in calm markets.
Calm markets are best suited for this type of trade.
They yield relatively better returns in low volatility scenario.
Example of a Yen Carry Trade
Perhaps, I can explain the yen carry trade better with an example.
Let’s say that you decide on a yen-dollar carry trade pair.
At this particular juncture, the rate in Japan is around 1%.
The corresponding interest rate in the US is close to 5%.
So, the trader expects around 4% profit.
This is the difference in the rates of the two currencies.
So, your first step is to get yen and then convert that to dollar.
Now, investing this dollar in US securities yields a higher rate.
The current exchange rate is around 113 yen per dollar.
Let’s assume the total yen borrowed is around 50 million.
So, then now convert this into the dollar.
50 million yen / 113 = $442,477.87
Now let’s say the carry trade investor invested this at 5% rate for 1 year.
So the total amount after 1 year is
$442,477.87 x (1 + 5%) = $464,601.76
But now, you must return the yen that you borrowed initially.
So, you owe 50 million yen at 1% interest rate for 1 year.
50 million yen + (50 million yen x (1 + 1%)) = 50.5 million yen
Now say that the exchange rate is close to current levels.
Remember we talked about range bound trade.
So the total amount that you need to return is 50.5 million yen/113 = $446,902.65
So your profit is the difference between the two balance.
$446,902.65 – $442,477.87 = $4424.78 is the profit.
Now the quotient will be exactly the rate of interest that you are taking advantage of.
The point that you must remember is the value of yen.
Your entire profit is dependent on the yen’s weakness.
The weaker the yen, higher is your profit.
The concern is would that be a viable strategy to rely on?
Factors for Effective Yen Carry Trade
Thus, what are the key factors for a profitable yen carry trade?
Well, we already told you the first factor in the carry trade is choice of currency.
In this case, we have already decided to bet on the yen-dollar.
Now with this key element in place, let us look at the other key elements.
Volatility: Yes that is the buzz word in yen carry trade
You have to choose a time when volatility is relatively low here.
This will mean sudden fluctuations are relatively low.
It also means a sudden reversal of trend is unlikely.
Almost inevitably, the trade proceeds with a certain degree of precision.
There are lots of assumptions in it.
The interest rate, the exchange rate and economic policy are uncertainties.
For a successful strategy, you need to make sure that all these are stable.
In this context, low volatility conditions are best suited.
Import-Export: In yen-carry trade, the unique nature of Japanese economy is important.
Japan is dependent on large oil imports.
They also import most of the natural resources.
Therefore, rising commodity prices can affect the economy.
That also means that the yen price can be affected.
A global slowdown can also have a negative impact on prices.
The state of the economy of Japan’s trading partners is crucial.
This is because most of the revenue inflow is via exports.
Any potential slowdown there can cost the yen precious points.
The BoJ intervention is likely the moment yen rates are threatened.
So, your trade has to take into consideration this key factor.
This is because that can be a real hindrance.
It can completely throw a well-planned strategy out of gear.
Depending on the Yen’s Weakness Can Be Risky
Now, the question is should you depend so much on a weak yen?
Well, for most yen carry trade investors, this is the biggest risk for the markets.
Too much of borrowing or extensive trade can impact the price.
In fact, it can in many ways spike up the value of the yen.
The yen’s weakness is a function of central bank action.
Moreover, you also need to look at the stance taken by other central banks.
You have to move ahead with the assumption that interest rates will be low.
The Bank of Japan is expected to maintain its rates low.
But the overall yen value has a tendency of rising above the ideal levels.
This can directly impact the overall trade positions.
It can erode your profits and can even make the trade unviable to an extent.
Remember that this carry trade is a leveraged trade.
There is no benefit in maintaining the second position.
You can only benefit if your leverage is one the right side.
In case you are at the wrong end of the trade, you can burn your fingers really bad.
The most important risk is you have no role.
Central bank actions, global liquidity conditions are the most important triggers.
Everything is deeply dependent on this single factor.
So if an investor is caught in crosswinds, it will completely throw the balance.
That is why timing too is crucial in this trade.
In case you don’t time it properly, your losses can be quite huge.
Why Is the Yen Carry Trade Back?
Well, this is exactly why it is interesting to appreciate the current trade.
The Yen Carry Trade is back with a bang.
Risk is the middle name in most investment market moves.
But this is one opportunity where the balance is tilted towards rewards.
Are you wondering how?
The dollar has seen some stupendous gains against the yen in recent times.
There has been a massive 15% gains in a matter of months.
Now imagine what that kind of gain can mean for your portfolio?
Not just that, the Japanese Government bonds are also favorably poised.
The Bank of Japan has committed a 0% rate in the near future.
Therefore, your overall short side risk is much lower.
That is if you go ahead and short the Japanese bonds.
Of course, given the market gains and dollar’s rise, this seems a profitable option.
What’s particularly reassuring is that the current markets are stable.
The dollar’s value is unlikely to recede in the near future.
So, the risks at both the long side and short side of the trade are limited.
There is a limited uncertainty about policy matters.
You can almost be very sure about the projected exchange rates going forward.
Well, that means your carry trade opportunity is almost presented on a platter.
Currently, hedge funds are sitting on huge cash ready to deploy.
Therefore, it won’t be wrong to suggest that this is the time to go long on the dollar.
If dollar-yen is your chosen pair, there is no better time to short the yen.
The global markets and economic conditions are all in favor.
Therefore, it is needless to mention that returns will follow.
Factors Helping Yen Carry Trade Today
Perhaps it is for this reason that you see a reemergence of the yen carry trade.
Again and again, we are hearing discussions about why it is a viable option now.
The global financial markets are finally out of the grip of recession.
As a result of this, most countries including the US are raising interest rates.
But Japan, as we mentioned, is committed to a low rate scenario.
This is because challenges for the Japanese economy continue.
The BoJ has been on a quantitative easing overdrive.
However low-interest rates and QE notwithstanding, the yen has gained ground.
That means the government has very little leeway regarding rate hike.
There are a few more interesting developments along with that.
The yen has also expanded its global reach in the interim.
Its share in global forex trading is almost around 25%.
Moreover, forex traders continue to look at the yen as a hedge.
The moment there is dollar weakness, yen position is increased.
This keeps the demand scenario also buoyant.
So, if you want to take advantage of the rate difference, this could be your best bet.
Advantages of Yen Carry Trade
Now I know that this is a great time for yen carry trade.
The question is, what are the advantages of this trade?
Is it worth all the risk and calculation to go ahead and take the position?
For that, I think you need to look at a realistic aspect of the trade.
This will help you identify the advantages of this trade.
Well, the scope of profit is significant if you work on the trade properly.
The carry trade can yield large returns when markets are stable.
If the currency of the high-interest nation increases, this further spikes profit.
When you look at the dollar situation now, it is absolutely favorable.
So in many ways, yen carry trade helps you take advantage of the trend.
It can enable you to earn huge profit in a limited period.
With some simple mathematical combinations, you can turn an adversity into advantage.
Therefore, yen carry trade is also an example of the stupendous opportunity.
Investment is all about great returns.
This is one of the best platforms to showcase this simple fact.
The foreign exchange market is huge today.
Almost $6 trillion worth of trade happens on a single day.
Connectivity and internet have opened up the scope for investors.
Time zones and geographical positions have no relevance now.
All the global markets are interconnected.
You get the most reliable opportunity to capitalize on connectivity.
Moreover, you can now take advantage of global economic developments.
Imagine Yen reacts to Abe, dollar responds to Trump, but gains pour into your account.
Yes, indeed carry trade is the simplest representation of benefiting from the policy.
Disadvantages of Yen Carry Trade
But remember that every coin has two sides.
The whole trade is based on the premise of low volatility situation.
As a result, any sudden change can completely alter the realities.
What is more worrying is you can lose money on both sides.
Whether you are on the long side of the trade or short side, the risks are huge.
Moreover, you are working on borrowed positions.
That means your liability in yen carry trade becomes huge.
Think about the profit percentage.
The loss prospects can be equally huge.
If there is too much spike, sometimes traders may not even have the minimum cash.
So, that means you lose the entire investment.
Therefore, you need proper market understanding.
It is never wise to plunge into this trade blindly.
Most importantly, your window to exit is limited.
If the trade reverses, the ship sinks in totality.
The scope of an easy escape is rather remote.
Therefore, we can conclude that global conditions favor a yen carry trade now.
As world markets are reviving, traders are once again ready.
A stable economy and strong dollar are all favorable factors.
So if you are an astute carry trade believer, this is your opportunity.
Shorting the Japanese currency can reap rich benefits.
But, it has some collateral damages too.
Simply imagine the impact on the US economy.
A strong dollar can impact US stock prices.
Similarly, a strong dollar also weakens commodity prices.
So if you have a healthy interest in these assets, watch out for yen carry trade.