The Yen Carry Trade: What does that mean?

A good friend of mine who is well-versed in the financial world, and quite successful with his money I might add, asked what I was talking about when I said the "unwinding of the Yen carry trade was a good trading opportunity."

The Yen carry trade is a specific example of a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates - which can often be substantial, depending on the amount of leverage the investor chooses to use.

Here's an example of a "yen carry trade": let's say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that 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. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, 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. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.

So the "unwinding" occurs when the investors needs to get out of the trade to avoid the aforementioned huge losses. That's where volatility is generated as well- the risk of huge losses leads to "panic selling." And this also explains why my good friend is not familiar with the term: he invests in relatively safe, low risk (beta) vehicles.