Blog Post

Prospects for the yen carry trade

Certain carry trade strategies could contribute to financial market volatility and should thus be monitored by institutions responsible for financial stability. The volume of open carry trade positions also carries information about the risk appetite of investors. This contribution assesses the prospects for the Japanese yen carry trade on currency markets. ‘Carry trade’ refers to […]

By: and Date: February 2, 2012 Topic: Global Economics & Governance

Certain carry trade strategies could contribute to financial market volatility and should thus be monitored by institutions responsible for financial stability. The volume of open carry trade positions also carries information about the risk appetite of investors. This contribution assesses the prospects for the Japanese yen carry trade on currency markets.

‘Carry trade’ refers to a risky financial position in which an investor borrows in a low-yield instrument and invests in a high-yield instrument, or engages in a transaction similar to this. A bank borrowing from a central bank and lending these funds to its customers at a higher interest rate, or purchasing higher-yielding securities, is also a kind of carry trade. If customers repay and the securities do not default, banks make a profit.

Figure 1: Three-month interbank interest rates (%), Jan 1986 – Dec 2011
Sources: Datastream and Reserve Bank of New Zealand.
But carry trade is most frequently mentioned in the context of currency markets: currencies with the higher interest rate are purchased against currencies with the lower interest rate. Since the mid-1990s Japanese interbank interest rates are close to zero, suggesting that the Japanese yen could be a candidate for funding carry trade positions (Figure 1).

There are various ways to conduct carry trade. A simple way is to sell a low-yield currency (eg yen) and buy a high-yield currency (eg New Zealand dollar). But one need not possess a low-yield currency: borrowing in a low-yield currency, exchanging it for a high yield one and purchasing a government bond of this high-yield currency creates a leveraged carry trade exposure, whereby the investor is exposed to the return/risk of the full amount of the loan. Foreign currency margin trade could also be used: the investor needs to open a margin account and put a certain amount of money there. Then the financial services provider does the borrowing/lending operations behind it, and the investor can open a foreign currency position amounting to several factors of his/her deposit, thereby increasing both risk and expected return. There are various other derivative positions for setting-up carry trade positions.

The incentive to open carry trade positions also depends on the traders’ appetite for risk. If other conditions are the same, the volume of carry trade expands with a high-risk appetite and reduces with a low-risk appetite. We found some evidence for this relationship when looking at some measures of carry trade volume and the VIX index (the implied volatility index of S&P 500 index options).

Figure 2: Yen exchange rates, Jan 1990 – Dec 2011
Source: Bank of Japan and Reserve Bank of Australia.
Note: A lower value indicates a stronger yen.

The exchange rate between the funding currency (eg yen) and the investment currency (eg New Zealand dollar) affects the rate of return on carry trades. Expectations about future changes to the exchange rate impact the decision to enter a carry trade strategy. When devaluation of the yen is expected, the expected rate of return for the yen carry trade rises and motivates investors to invest.

On the other hand, a high volume of carry trade activities can also impact the exchange rate, especially in markets in which currency turnover is not that large. For example, interest rates were very high in Iceland, attracting a large inflow of carry trade investment before the crisis, ie euros and dollars were exchanged for Icelandic kronas leading to the appreciation of the Icelandic krona’s exchange rate. When carry trade investors tried to pull out their earlier investment during the course of the financial crisis, the korna depreciated massively.

Before the crisis, the yen depreciated significantly against the Australian and New Zealand dollars (Figure 2), thereby making the yen carry trade highly profitable. But after the collapse of Lehman Brothers the yen appreciated sharply against the Australian and New Zealand currencies – by about 40 percent –, leading to severe losses for carry trade investors (Figure 3). Recently, there was no visible trend, but exchange rates were volatile).

Figure 3: Cumulative returs to 100 initial non-leveraged carry trade in yen against five currencies, Jan 2000 – Dec 2011
Source: Updated from Darvas, Zsolt (2009) ‘Leveraged vary trade portfolios’, Journal of Banking and Finance, 33(5), 944-957.
Note: Transactions costs are considered, but not the interest income of collateral.

How did yen carry trade positions evolve? There are various markets in which carry trade positions can be taken and certainly not all foreign currency transactions are motivated by carry trade. Open positions on the Tokyo International Financial Futures Exchange are indicated in Figure 4. Before the crisis, there was a clear trend of increasing long positions in foreign currencies, while short yen positions have also increased somewhat – consistent with carry trade. At the time of the collapse of Lehman Brothers there was a significant decline in open positions because of the sharp appreciation of the yen and the consequent losses on carry trade positions, which induced investors to close these positions. Figure 3 shows the return on non-leveraged positions, but losses on leveraged positions were of course much higher. The heightened risk aversion that emerged, and investor losses on other financial products, have also reduced their capacity to engage in derivatives positions. However, already from mid-2009, the open positions increased dramatically, reaching a peak in summer 2011. Since then, open positions have declined somewhat.

Figure 4: Foreign-exchange margin trade at the Tokyo international Financial Futures Exchange ($100 millions), 10 July 2006 – 31 Dec 2011
Source: Tokyo International Financial Futures Exchange. Note: Yen short positions (ie investors ‘selling’ the yen) are the aggregate of short positions against seven major currencies: US dollar, Euro, Australian dollar, New Zealand dollar, Canadian dollar, British pound and Swiss franc. Foreign currency long positions (ie investors ‘buying’ foreign currencies) are the aggregate of long positions against the yen for the same seven currencies.

Trade through an interoffice account between the branch of a foreign bank in Japan and its head office abroad is another way of conducting yen carry trade. The Japanese branch of a foreign bank lends funds to its head office by funding the yen in the Japanese interbank market, and the head office invests those funds in high-profit assets. When the volume of the yen carry trade expands, the net borrowing position (interoffice borrowing > interoffice lending) declines, or converts into a net lending position (interoffice borrowing < interoffice lending).

In the 1990s and early 2000s, the interoffice borrowing of these branches exceeded their lending (Figure 5). But from about 2004 to 2007 the net borrowing position turned to net lending, possibly implying the presence of carry trade. After June 2007, and the outbreak of the US mortgage crisis, net lending declined to a level of close to zero up to late summer 2008. After the collapse of Lehman Brothers it declined further to minus ¥10 trillion (close to the historical average) and did not recover since then. This suggests that carry trade through interoffice lending of banks’ branches in Japan has not yet returned.

Figure 5: Interoffice account net position of foreign banks’ branches, January 1990 – November 2011 (¥ trillion)
Source: Bank of Japan.
Note: Net position = lending minus borrowing.

To sum up, the open positions of margin trades at the Tokyo exchange are almost at a historical high, though has declined during the past half year, and interoffice lending of foreign banks’ branches are at the historical average. Risk appetite may fall due to the downgrade in the US credit rating, the fiscal crisis in Europe and the possibility of a double-dip recession. This may give rise to further unwinding of yen carry trade positions and an increase in market volatility.



Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Balancing free trade with national security interests

In this episode of Director's Cut, Stephanie Segal of CSIS joins Bruegel's Guntram Wolff and Maria Demertzis for a conversation about the tension between free trade and national security issues, and the emerging threats to multilateralism.

By: The Sound of Economics Topic: Global Economics & Governance Date: February 19, 2019
Read about event More on this topic

Past Event

Past Event

The world’s response to China’s Belt and Road Initiative

This event will look at the Chinese Belt and Road Initiative as well as the response from the rest of the world.

Speakers: George Cunningham, Uri Dadush, Jean-Francois Di Meglio, Theresa Fallon, Alicia García-Herrero and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 8, 2019
Read article Download PDF More on this topic

Policy Contribution

Russia's growth problem

After the 2014-2016 currency crisis, Russia’s economy has returned to growth, albeit at a slow pace. In this Policy Contribution, the authors analyse the potential causes of mediocre growth performance, as well as its impact on Russia's economic and political relationships. They also include their recommendations for the future.

By: Marek Dabrowski and Antoine Mathieu Collin Topic: Global Economics & Governance Date: February 7, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Reflections on five years of China's Belt and Road Initiative

Bruegel fellows Alicia García-Herrero and Uri Dadush join Guntram Wolff for this Director's Cut of 'The Sound of Economics', focusing on the progress made by China's Belt and Road Initiative, how it will continue to develop, and the reactions it has stirred across the world.

By: The Sound of Economics Topic: Global Economics & Governance Date: February 7, 2019
Read article Download PDF More on this topic

Working Paper

Countries’ perceptions of China’s Belt and Road Initiative: A big data analysis

Drawing on a global database of media articles, the authors quantitatively assess perceptions of China’s Belt and Road Initiative (BRI) in different countries and regions. They also identify the topics that are most frequently associated with the BRI.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: February 6, 2019
Read article More on this topic More by this author

Blog Post

The American tax debate

The debate over two different proposals for tax reforms: Senator Elizabeth Warren’s plan for a tax on wealth, and Congresswoman Alexandria Ocasio-Cortez’s plan for a higher top marginal tax rate on income

By: Enrico Bergamini Topic: Global Economics & Governance Date: February 4, 2019
Read about event More on this topic

Past Event

Past Event

Why facts and think tanks matter

How can Think Tanks help address today's policy challenges by providing fact-based policy recommendations. What is the importance of international cooperation for Think Tanks?

Speakers: Tommaso Canetta, Giuseppe Porcaro, Sophie Gaston and Stefani Weiss Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: January 31, 2019
Read article More on this topic More by this author

Blog Post

Chinese growth: A balancing act

China’s GDP growth in 2018 was 6.6%, its lowest annual growth rate in more than two decades, and the rate is expected to slow further this year. What is driving the slow-down in Chinese growth and what are the implications for Chinese policymakers and the global economy? This post reviews the blogosphere’s take.

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: January 28, 2019
Read article More by this author

Podcast

Podcast

Backstage: Policy principles for a new social contract

This episode of The Sound of Economics features Bruegel senior fellow Zsolt Darvas in conversation with Maurizio Bussolo and Bernadette Ségol about income inequality in Europe and Central Asia, and the policy principles underpinning a possible new social contract.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Global Economics & Governance Date: January 24, 2019
Read about event More on this topic

Past Event

Past Event

Rules-based trading system and EU-Australia

At this event the Australian Minister for Trade, Tourism and Investment, Senator the Hon Simon Birmingham will speak about Australia-EU bilateral trade, the FTA negotiations and the importance of multilateral rules-based trading system

Speakers: Senator the Hon Simon Birmingham, André Sapir and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: January 22, 2019
Read article More on this topic More by this author

Opinion

Elections, institutions and statecraft: A tumultuous year for Modi in India

With the turn of the year, India has firmly entered election mode. Recent regional elections have begun to shift the political landscape, while tensions continue to simmer between the Reserve Bank of India and the Ministry of Finance. How the Modi government sees out this term could set important precedents for the incoming government in May 2019.

By: Suman Bery Topic: Global Economics & Governance Date: January 16, 2019
Read article More by this author

Blog Post

What 2019 could bring: A look inside the crystal ball

Economic performance prospects in Europe, the US and Asia in 2019. We start off by reviewing commentaries and predictions about the euro zone, which many commentators expect to perform below potential as uncertainties continue to dampen a still robust recovery.

By: Michael Baltensperger Topic: European Macroeconomics & Governance, Global Economics & Governance Date: January 14, 2019
Load more posts