Carry of an asset can be defined as the return earned out of just holding an asset if positive or as the cost of holding the asset if negative. Holding commodities is an example of a negative carry unless the market is willing to pay a premium for availability. Carry trade is defined as the spread between borrowing a low carry asset and lending a high carry asset. It is different from arbitrage as arbitrage is the spread earned between similar assets quoting at different levels and is made only till nothing changes.
Therefore, yen carry trade is defined as earning a spread by borrowing low yielding (almost zero) yen and lending a high yielding currency like a US Dollar or a GB Pound. The trader earns a spread between the yields and also from the dynamics in the value of the two currencies. It tends to correlate with global financial and exchange rate stability. This spread so earned can be magnified if the trader leverages this type of trade. It can be further enhanced if the so leveraged bought yen is invested into a still higher yielding stock market. The greed does not end here. The returns can still be enhanced if the cheaply acquired liquidity is invested into a still higher yielding stock market amongst the economies termed as developing economies. This concept has actually been implemented and today there has been such huge liquidity across the globe emanating from a cheap source, Japan. It is estimated that as of early 2007, as much as USD 1 trillion may be staked on the yen carry trade.
Post the dotcom bubble burst in 2000, monetary authorities across the globe had slashed the interest rates to support growth. Where countries like UK and US have tightened the rates, Japan has been a laggard and has still kept a zero interest rate scenario to keep the Japanese exports competitive. This has been helping Japan to support its economy but at the same time it has also created a huge liquidity into the markets, which are now globally interconnected.
Appreciation of the Japanese yen, increase of interest rates in Japan or reducing returns out of the lent currency, stock markets, bonds or real estate will make the carry of the Japanese yen expensive. Further, for a leveraged trader, the cost of this carry will magnify just as his spread earnings had magnified in the earlier case. This will lead to the trader unwinding his carry and thus will make him borrow a higher yielding currency to pay back the lower yielding currency.. Something similar has happened before. Nine years ago, panic in the global financial markets sent the yen surging 20% in less than two months. In May, 2006, the Bank of Japan withdrew excess liquidity by 12.2 trillion yen–equivalent to the Fed taking $200 billion out of excess U.S. liquidity. In the first case, however, the sudden appreciation in the yen worsened the Japanese economy and in the second case, the bank of Japan realized the panic it had triggered and it again started pushing liquidity in the system. This resulted in the stock markets shooting up post May 2006. Therefore, if the unwinding is triggered by the intervention of Japan, it may have to face a trade-off as an unbalanced economy and hence can be corrected but if it is triggered by a global slowdown, it becomes beyond control and may have rippling effects across the globe.
Where, an unwinding of the yen carry trade can have a significant impact on global financial instruments including real estate, the yen carry trade has also been benefiting the global economies for almost a decade. The liquidity so created in the system has actually created a lot of value in stock markets across the globe and there is a lot of Foreign Institutional Investor (FII) activity among the emerging economies. It has also triggered a lot of real growth in these economies.
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