Yen Carry Trade: Impact on financial market
Published by Sharekhan Education | August 27, 2024
What is Yen Carry Trade?
Yen Carry trade is a type of investment strategy in which investors borrow money in low-interest-rate currencies (funding currency) and then lend this sum or invest it where there are higher interest rates, ultimately hoping to make profit on the difference. This allows you to capitalize on the “carry” between interest rates.
Example of Yen Carry Trade
Let’s say an Investor takes out a loan of 10 million Yen at a 0.25% interest rate from Japan. They then change this to US dollars at an exchange rate of 1 USD = 100 Yen. This gives the investor $1,00,000. They put this money into US bonds with a 3% return.
Interest to pay in Japan: 0.25% of 10 million Yen = 25,000 Yen=$250
Interest to earn on US bonds: 3% of $1,00,000 = $3000
Investor makes= $3000-$250=$2750
The carry trade can make more money if the target currency goes up against the funding currency. But if the target currency goes down, the carry trade can result in losses.
Historical Context Yen Carry Trade
Yen Carry trade tactics have gained popularity when global interest rates were low. The yen carry trade became common in the 1990s and 2000s as Japan kept interest rates close to zero. Investors took out loans in yen and put money into currencies with higher yields such as the USD or those from emerging markets. As computer-based trading grew automated systems started to handle carry trade tactics more often. These systems can adjust to changes in interest rates and market situations. But carry trades have also played a role in financial crises. When large carry positions unwind, it can make currency values swing more.
Risks of yen Carry Trade
The primary risk in carry trade is the fluctuation in exchange rates. If the target currency depreciates against the funding currency, the potential profits can be wiped out or even turn into losses. Political instability or economic crises in either of the countries involved can lead to sudden and unexpected changes in currency values. Carry trades often involve significant leverage, amplifying both potential gains and losses. In times of financial stress, liquidity in certain currencies can dry up, making it difficult to exit positions without incurring significant losses.
Effect of Yen carry trade in Indian stock market:
As an emerging marking, India is safe to the yen funding and therefore there could be a adverse affect on Indain inventory marketplace when this might get unwinded. If the yen moves stronger further, Japanese Foreign Portfolio Investors (FPIs) who have significant exposure to Indian equities would be inclined to sell leading The Nifty. And Indian firms having yen loans of long tenure could face mounting debt servicing burden since the Japanese currency has strengthened. Low-cost capital from Japan for infrastructure projects has been another benefit to India but higher interest rates in Japan could mean paying more to borrow yen;
How should Indian Investors react ?
We believe this could have the effect of moving money from more commodity lower-quality segments to companies with earnings. While short-term volatility may persist, adopting a long-term investment strategy that emphasizes quality and growth is expected to yield better returns. It’s advisable to stay invested in fundamentally strong companies that are well-equipped to navigate market uncertainties and deliver sustainable growth. Emphasize large-cap stocks, as they typically provide greater stability and resilience, particularly during volatile market conditions. Investors should steer clear of SME, microcap, and speculative ‘hope story’ stocks.
Conclusion
Carry trade has clear potential benefits, but it also comes with big risks you can’t ignore. Currency values can change in ways you can’t predict, and even small shifts in exchange rates can change your results. To handle these tricky situations, you need to understand both the strategy and what’s happening in the market. Sharekhan Education wants to help you gain this knowledge giving you the tools to make smart and strategic choices about where to put your money.
Disclaimer
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