Wednesday, August 1, 2007

Investment Bubble 2 - Yen Carry Trade

Stock markets had surged over the past few years. One reason is the aplenty liquidity in the market. Other than the oil nations pumping in billion of dollars, there are people doing "Carry Trading" in the market. What am I talking about? Let me share in this short posting.

What is Carry Trade?
It is a situation when investors and speculators borrow a currency with low interest, such as Yen, to buy a higher returns assets such as equities, commodities or even currencies with higher interest. One classic example is the "Yen Carry Trade"

Why is Yen so popular?
Japan has for many years suffered from deflation. To stimulate growth and revive economy, they kept short-term interest rate at nearly 0%.
This low interest rate policy means ultra low borrowing cost. Hence investors all over the world flock to borrow the cheap Yen.

What can cause the carry trade to unwind?
If Yen appreciates sharply and abruptly for whatever reason or the Government decides to raise interest rate sharply in a short period of time.

What will happen if the Yen Carry Trade unwind?
When the Yen appreciates sharply, investors may be forced to sell the assets or currencies which they purchased with their borrowed Yen.

So whats the conclusion?
If there are no control on the Yen Carry Trade and for whatever reason the Yen changes direction and strengthens, it can cause a large global imbalance that could destablise the financial markets.
This risk is factored in the current stock market. Though we don't expect the Yen Carry Trade to unwind that soon, the risk is that it may happens anytime without warning.

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