Home > Trading Ideas > How Yen Carry Trade affects our markets?

How Yen Carry Trade affects our markets?

Tuesday, August 21, 2007 Leave a comment Go to comments

First the definition.(Source-investopedia)

Currency Carry Trade:

A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates – which can often be substantial, depending on the amount of leverage the investor chooses to use.

Example:

Here’s an example of a “yen carry trade”: let’s say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let’s assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% – 0%), as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The RISK:

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.

The Dollar-Yen Chart:

Every time the dollar falls with respect to yen, one feels the carry trade jitters in Indian markets.This is because people rush to unwind these carry trades. Just observe how the dollar got into a downward trend and is falling with respect to yen.Also note how the beginning of rapid fall coincided with our market top on July 24-26.

jpy.jpg

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