BoJ sneezes, rest of the world catches cold
The term “carry trade” without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend high-yielding ones. The risk of carry trades is that foreign exchange rates will change, and the investor will have to pay back now more expensive currency with less valuable currency.
In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the target currency, because investors sell what they have borrowed, and convert it into other currencies.
For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into $$ and buys a bond for the equivalent amount. Assuming 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. Leverage can make this type of trade very profitable. If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (4.5% * 10). However, 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. Furthermore, because of the leverage, small movements in exchange rates can magnify these losses immensely unless hedged appropriately.
Meanwhile, emerging economies struggle to survive the torrent of carry trade money and markets become more volatile. As of early 2007, almost a trillion dollar is locked into Yen carry trade positions.
There is an enduring idea that if the "the market" sets the price of currencies, equities, commodities, and other assets, then this is somehow better. The market knows best. But if "the market" is dominated by hedge funds with easy access to cheap money, this can be more destabilizing than beneficial.
Tim Iacono submits Much of the blame for last week's shellacking of financial markets around the world has been attributed to the "unwinding" of the Yen carry trade. That is, when hedge funds and other financial institutions closed out investment positions funded by money borrowed at low rates of interest from Japan.
After the Bank of Japan raised interest rates a few weeks back, the Yen strengthened and the higher borrowing cost combined with a narrowing exchange rate differential began to eat into investors' gains.
Spurred by a recession warning from Alan Greenspan and the plunge in the Shanghai Composite index last Tuesday, carry trade profits were promptly taken, resulting in the sale of stocks, commodities, currencies, probably a few paintings, and who knows what else.
This distorts the entire exchange rate picture and only benefits hedge fund managers and their investors. There is no discernible improvement in the "allocation of capital" - it's just "asset shuffling".
Down went the investors in the poor third world, thanks to smart money movements initiated by the Hedge Fund managers. Well, obviously there are some lessons here for everyone.
You can find the full report here.