Investing UDS to JPY

Investing USD to JPY

What is the carry trade?

This is a popular strategy that arbitrages the difference between interest rates in different countries by borrowing in one currency and investing in another. Traditionally the carry trade has occurred between the US and Japan. Traders would borrow funds from Japan in Yen (where interest rates have been very close to zero to some time) and then convert the money to US dollars and invest in say bonds that pay around the 5% mark in interest rates.

This strategy seems like a sure fire winner and quite often it has assuming all other things remain equal. However every investor should know that rarely do all things remain equal, especially exchange rates. If exchange rate move against the trader (in the above example if the dollar were to weaken against the Yen by say 6%) any profits made from the difference in interest rates can be quickly eroded and turned into a loss.

The carry trade has been in existance for many years and in 2007 it is estimated that as much as $1 tillion USD was being traded on the yen. This trade dispels the popular theory of interest rate parity that states that the difference in the interest rates of two countries will show you how much the weaker currency is expected to appreciate against the one with higher interest rates. In reality this theory has been proved wrong, or at best as having a huge time lag as many billions of dollars have been made in recent years off the carry trade.

What factors affect the USD/JPY rates?

There are almost an unlimited amount of things that can affect the USD/JPY exchange rate including; liquidity in the money markets, inflation, interest rates, governement borrowing, economic recessions, oil prices or even political unrest or uncertainty. Historically when the Japanese yen has strengthened it has done so rather quickly. When this happens it can dish out hefty losses to holders of the carry trade.

In much the same way as individuals have used cheap credit in recent years to fuel their consumption of goods, traders and banks have used the cheap interest rates in Japan to fuel their profits by seeking returns elsewhere (i.e. the US). This is likely to continue for some time as long as te Yen remains cheap (many analysts still believe it is undervalued). However with the global credit crunch removing liquidity from the financial markets, many people are wondering how this will affect the USD/JPY speculators and the future of the carry trade.