How Big Is the Yen Carry Trade and What It Means for Markets

The yen carry trade is a complex phenomenon that has significant implications for financial markets. A staggering $1 trillion is estimated to be invested in the yen carry trade, with investors borrowing yen at low interest rates to invest in higher-yielding assets.

This massive investment is fueled by the Bank of Japan's (BOJ) monetary policy, which has kept interest rates in Japan extremely low. The BOJ's policy of quantitative easing has led to a depreciation of the yen, making it cheaper for investors to borrow.

Investors are attracted to the high yields available in other currencies, such as the Australian dollar and the New Zealand dollar, which can be as high as 2-3% per annum. The carry trade allows investors to earn these higher yields while still benefiting from the low interest rates in Japan.

The yen carry trade is not just a simple investment strategy, but a major driver of global financial markets.

A currency carry trade is a strategy where traders borrow in a low-interest-rate currency and invest in a high-interest-rate currency, aiming to profit from the interest rate differential.

The currency carry trade is one of the most popular trading strategies in the forex market, and it's similar to the "buy low, sell high" motto.

To enter a carry trade, you need to determine which currency offers a high yield and which offers a lower one. This was the case with the Japanese yen, which offered wide spreads against many global currencies like the Australian dollar and the New Zealand dollar from the late 2000s to mid-2024.

Many professional traders use the carry trade because leverage allows them to magnify the potential gains. If the exchange rate between the currencies doesn't change significantly, the trader profits from the difference in interest rates.

The funding currency is the currency exchanged in a carry trade transaction, typically characterized by a low interest rate. Investors borrow the funding currency and go short, while taking long positions in the asset currency, which has a higher interest rate.

If a trader borrows in the Japanese yen, which has a rate of 0.5 percent, and invests in the U.S. dollar, which has a rate of 4 percent, they can expect to collect a 3.5 percent spread.

This spread is the difference between the ending U.S. dollar balance and the amount owed, which is exactly the expected amount. If the exchange rate moves against the yen, the trader would profit more, but if the yen gets stronger, the trader would earn less than 3.5 percent or may even experience a loss.

To get started with currency trading, you need to understand the basics of a currency carry trade. A currency carry trade is a strategy where you borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency, aiming to profit from the interest rate differential.

The first step is to determine which currency offers a high yield and which offers a lower one. For instance, the Japanese yen was known for offering wide spreads against many global currencies, such as the Australian dollar (AUD) and the New Zealand dollar (NZD), from the late 2000s to up until mid-2024.

To enter a carry trade, you'll need to find a low-yielding currency to borrow in and a high-yielding currency to buy. This strategy can be entered by simply finding and selling a low-yielding currency and buying a high-yielding one, often using leverage to magnify any potential returns.

Getting in a carry trade is a good idea when central banks are raising interest rates, as this will push up the value of the currency pair. This is evident in the currency carry trade example where the trader borrows yen and invests in the U.S. dollar, profiting from the 3.5% spread.

Low volatility is also a favorable condition for carry trades. Traders are willing to take on more risk during times of low volatility, making it easier to collect the interest rate differential.

A period of interest rate reduction is not ideal for carry trades. When rates are dropping, demand for the currency tends to dwindle, making it difficult to sell off the currency. This is why a period of interest rate reduction won't offer big rewards in carry trades.

The trader in the currency carry trade example profited $15,217.39 from the 3.5% spread, which is exactly the expected amount. This illustrates how carry trades can be profitable when the conditions are right.

A currency carry trade is a strategy where you borrow in a low-interest-rate currency and invest in a high-interest-rate currency, aiming to profit from the interest rate differential. This is one of the most popular forex trading strategies.

The carry trade involves using leverage to magnify any potential returns. Many professional traders use this trade because leverage allows them to earn 10 times the interest rate difference.

You can enter a carry trade by simply finding and selling a low-yielding currency and buying a high-yielding one. Until recently, one of the most popular carry trades involved trading the low-yielding or even negatively yielding Japanese yen against currencies like the Australian dollar or the New Zealand dollar.

To illustrate this, let's consider an example where rates in Japan are 0.5 percent, and rates in the United States are 4%. If you borrow in the Japanese yen, and invest in the U.S. dollar, you can expect to collect the 3.5% spread.

Assume the current exchange rate is 115 yen per dollar and you borrow 50 million yen. Once converted, you would have U.S. dollars equal to $434,782.61. After a year invested at the 4 percent U.S. rate, your ending balance would be $452,173.91.

You still owe the 50 million yen principal plus 0.5 percent interest for a total of 50.25 million yen. If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is $436,956.52.

The profit is the difference between the ending U.S. dollar balance and the amount owed, which is $15,217.39. This profit is exactly the expected amount: $15,217.39 ÷ $434,782.62 = 3.5%.

The yen carry trade is a complex strategy that involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency. This can be a high-risk, high-reward strategy.

Uncertainty of exchange rates is a major risk of a carry trade, as seen in mid-2024 when the U.S. dollar fell in value relative to the Japanese yen. The Bank of Japan raised its rate, causing a huge loss for traders who had borrowed in the yen.

Even a small movement in exchange rates can result in huge losses due to the use of leverage. Unless the position is appropriately hedged, this can be devastating. I've seen many traders get caught off guard by unexpected market movements.

The future direction of interest rates is crucial in a carry trade strategy. For example, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is finished tightening its rates.

Carry trades generally only work when the markets are complacent or optimistic. Uncertainty, concern, and fear can cause investors to unwind their carry trades, resulting in significant losses.

Uncertainty of exchange rates is a significant risk in carry trades, as a sudden change in currency values can result in huge losses. This was evident in mid-2024 when the Bank of Japan raised its rate, causing the U.S. dollar to fall in value relative to the Japanese yen.

Carry trades often involve a lot of leverage, which means even a small movement in exchange rates can lead to massive losses unless the position is properly hedged. The 45% sell-off in currency pairs like AUD/JPY and NZD/JPY in 2008 is a stark example of this.

The direction of interest rates is more important than the current level of interest rates in a carry trade. A change in interest rate direction can cause a currency to appreciate or depreciate, affecting the trade's outcome.

Carry trades only work when markets are complacent or optimistic, but uncertainty, concern, and fear can cause investors to unwind their trades. The subprime crisis in 2008 is a classic example of this, causing a massive sell-off in currency pairs.

In a currency carry trade, traders borrow in a low-interest-rate currency and invest the proceeds in a high-interest-rate currency. This strategy generally involves using leverage to magnify any potential returns.

The goal of a currency carry trade is to profit from the interest rate differential.

Borrowing in a low-interest-rate currency and investing in a high-interest-rate currency is the core concept of a currency carry trade.

A vote of confidence in the future may be undercut by a lukewarm economy. This was evident in mid-2024 when the Bank of Japan raised its rate to levels not seen in over a decade, unwinding all the trades that involved borrowing in the yen.

The Bank of Japan's decision had a significant impact on carry trades, a strategy that involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency. In a currency carry trade, traders borrow the funding currency and go short while taking long positions in the asset currency.

Even a small movement in exchange rates can result in huge losses, unless the position is appropriately hedged. This was the case in 2008 when the subprime crisis turned into the global financial crisis, causing a 45% sell-off in currency pairs such as the AUD/JPY and NZD/JPY.

The future direction of interest rates is crucial in determining the success of a carry trade strategy. For instance, the U.S. dollar could appreciate against the Australian dollar if the U.S. central bank raises interest rates at a time when the Australian central bank is finished tightening its rates.