Japanese “Yen Carry Trade” explained with simple example

On August 5th, 2024, because of carry trade all the global markets in the world were showing a potential crash. The US markets fell significantly, wiping out almost $2 trillion from the market. All of this was triggered by just a small change in Japan’s banking policy.

Since 1987, the Japanese banks have charged almost 0% interest if you borrowed money from them. This changed last week when the Japanese government decided to raise the interest rate to 0.25%. 0.25% doesn’t look like much, but in a country where there has been no interest rate for the last few decades, it was too much.

But the biggest reason for the US market fall was the big investors doing a carry trade.

What is a carry trade?

As the Japanese markets were offering loans at 0% or very minimal interest rate, lots of big investors took the loans from the Japanese banks in yen. Then they converted that money to USD and invested in the US market. But as Japan hiked the interest rate, these big hedge funds and institutional investors got into trouble, and they started selling, ultimately causing the market crash as you can see in the above image.

How Carry trade actually works?

The first step is for the traders to borrow money from low-interest countries. In this case, it was Japan. Then they convert that money into another currency; in this case, it was converted to USD. Once converted, they invest that money in the US stock market, where you get more than a 0% return on your investment.

Carry Trade Example

Let’s say someone borrows 1 billion yen from Japanese banks at a 1% interest rate. Then they will approximately get around $7 million. That person takes those $7 million and invests in the US market for a return of maybe 5%. So the trader makes around $350,000 after investing in the US market. So now they have a total of $7,350,000. Now the trader will return the money to the Japanese bank at a 1% interest rate, which comes to a total of $7.07 million.

• Borrowed amount: ¥1,000,000,000 at 1% interest.
• Initial conversion: ¥1,000,000,000 / 142.857 ≈ $7,000,000.
• Investment return: $7,000,000 * 0.05 = $350,000.
• Total after investment: $7,000,000 + $350,000 = $7,350,000.
• Amount to repay: ¥1,010,000,000 / 142.857 ≈ $7,070,000.
• Profit: $7,350,000 – $7,070,000 = $280,000.

So in this trade, the trader has made a profit of $280,000. This is what an ideal carry trade is, and it used to happen with billions of dollars, where big investors and hedge funds used to borrow billions and make money on the interest rate difference.

Now, what could go wrong in this trade, and what exactly went wrong with recent changes?

Exchange rate fluctuation

The first thing that could go wrong is the USD/yen exchange rate going down by 10%, and you still owe 1 billion yen to the Japanese bank. Now, as the USD/yen exchange rate has gone down, you need more dollars to pay for the same 1 billion yen. Previously, you just needed $7 million for 1 billion yen. After the exchange rate went down by 10%, you will now need $7.85 million to pay the same 1 billion yen at 1% interest.

• New exchange rate: 1 USD = 128.571 yen (10% decrease).
• Amount to repay: ¥1,010,000,000 / 128.571 ≈ $7,850,000.
• New repayment amount: $7,850,000.
• Loss: $7,850,000 – $7,350,000 = $500,000.

Now, even if you make a 5% return on your USD investment, you still made a loss of $500,000.

Investment Value Decrease

In the second scenario, your USD investment value goes down. Let’s say the value of your USD investment goes down by 10%. Now the value of your investment is just $6.3 million. To pay the 1 billion yen with 1% interest, you need $7.07 million. In this case, you made a loss of $770,000.

• New investment value: $7,000,000 – 10% = $6,300,000.
• Repayment amount: $7,070,000.
• Loss: $7,070,000 – $6,300,000 = $770,000.

Interest Rate Increase

The third scenario is that the yen interest rate rises from 1% to 4%. Now, to pay back 1 billion yen, you need $7.28 million. You have to pay $280,000 from your original $350,000, reducing your total profit to $70,000.

• New interest rate: 4%.
• Amount to repay: ¥1,000,000,000 * 1.04 = ¥1,040,000,000.
• Repayment amount in USD: ¥1,040,000,000 / 142.857 ≈ $7,280,000.
• New profit: $7,350,000 – $7,280,000 = $70,000.
  

Here you profit has reduced significantly and we have not considered the exchange rate charges and taxes in this. It will reduce your profit significantly.

Imagine all of these three scenarios happening at the same time, and the losses made by this trader will multiply several times.

This is what happened on August 5th, 2024. The Japanese markets raised the interest rate by 0.25%. This caused carry traders to panic and sell off their positions in the US market as they were getting margin calls from the Japanese banks to pay back their money. What exactly is a margin call? We have explained it in this article while explaining the movie Margin Call.

This caused $2 trillion to wipe out from the US market, triggering the start of a potential recession. The market situation can change anytime, and when that happens, even the money in your bank is not enough as its value will reduce. That’s why you need to invest your money carefully with good returns to secure your financial future. For that, you need value investing, and to learn more about value investing, subscribe to our newsletter on our website.

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