If you are wondering how the strengthening of the yen vis-à-vis the dollar has anything to do with the the stock market meltdown, read on. Among the many reasons attributed to the slump in the world markets, the yen carry-trade is the one cited most often. But, before we learn how the yen carry-trade affected the stock market, a look at what "carry trade" is and how it works.
What is currency carry trade?
Currency carry-trade is a strategy by which an investor borrows in the currency of a market that offers low interest rates and uses the proceeds to fund the purchase of assets in a market that yields a higher interest rate. Thus, using this strategy, investors seek to pocket the difference between the rates, leading to gains, depending on the extent of leverage . Obviously, the key risk to such transactions is the uncertainty of how the two currencies will move relative to each other (exchange risk).
The yen carry-trade, in a similar manner, seeks to use the differentials between the Japanese yen and the US dollar. For example, an investor may obtain yen-denominated borrowings at an interest rate of 0.5 per cent. Now, as long as this can be invested for a higher return, investors could profit from the `spread' or `carry' between the two markets. Investing the funds in dollar-denominated bonds that pay 5 per cent, gives investors a spread of 4.5 per cent (5-0.5 per cent), assuming the exchange rate between the two currencies does not change during the holding period. When the same is done with leverage, the returns are phenomenal. If the dollar strengthens vis-à-vis the yen, profits get magnified; however, if the yen were to strengthen, losses can be sizeable too.
How carry-trade affects stock markets?
Since Japan has been holding its interest rates near zero for the past six years, the `yen' has emerged as a favourite currency for investors who indulge in carry trades. The ease of making money on the yen carry-trade has, in part, contributed to a higher risk appetite on the part of global investors. Investors began to take more risk, so much so that the funds arising out of yen borrowings were invested in emerging markets such as China and India, usually perceived more riskier than the developed markets. The going was good till the recent mark-up in Japanese interest rates and the meltdown in the Chinese market, which dragged portfolio values for many investors deep into red. Those who had borrowed a large sum of money in yen were forced to close their carry-trade positions to limit losses.
The hurried buying in the yen led to its strengthening vis-à-vis the dollar, forcing many investors, hitherto unaffected by the Chinese market correction, to unwind their carry-trade positions. This led to money flowing out of emerging stock markets, such as that of India, which depend to a significant extent on foreign institutional investors. A correction in the markets, thus, becomes imminent.
The sell-off in the Chinese market has snowballed into a global phenomena, leading to the meltdown in global indices. While such incidents have not made yen carry-trades unpopular, they have certainly forced investors to re-define their risk appetite.