Decoding the Carry Trades

It all started in Japan and rippled quickly through Asia, Europe, and the US, setting traders on edge over fears of a recession in the US.

Behind those fears of a US slowdown was concern over the stability of an investment strategy known as a “Carry Trade.”

The mechanics of carry trade are simple yet powerful!

A carry trade is an investment strategy that involves borrowing money in a currency with low interest rates and using it to invest in stock and bonds based on a currency with higher interest rates.

Example: In Yen Carry, investors borrow $1M Yen at 0.50% interest p.a. They convert the proceeds to another currency such as U.S. dollar where the funds are invested at higher interest rate (let us say 5% in money market account) for a term. At the end of the term, the investor converts the dollars back to yen to repay the loan, pocketing the difference as arbitrage gains.

Catch here is, if the spot rate at the end of the period is roughly the same as at start or the yen has fallen in value against the dollar, the investor profits.

So, what went wrong?

Yen has been a popular choice for carry trades due to Japan's long-standing policy of maintaining extremely low interest rates.

Firstly, on Aug 5th, Bank of Japan recently raised interest rates from nearly zero to 25 basis points, marking a shift in its long-standing monetary policy.

Secondly, this was amplified by expected interest rate cuts in the US over fears of a looming recession. This led to a strengthening of the yen against other currencies, including the US dollar.

Now, remember that carry trades rely on wide gaps between interest rates and currency prices to deliver a return for investors. These both had implications on the arbitrage gains on carry trades and posed threat to wipe out slim gains.

This evaporation of profits sparked a panic sell-off as traders looked to offload high-risk assets and resulting in a plunge.