Explainer: What are carry trades, how did they contribute to this week’s global market turmoil?

Here is what sounds like a sure-fire way to improve an asset’s returns: use cheaper money to buy it. That is the core of what is known as a foreign-currency carry trade. Investors take advantage of a difference in interest rates between two countries to borrow where the rate is low and invest where it is high.

Carry trades are especially popular when central banks in different parts of the world pursue diverging monetary policies, as one country might fight inflation while another seeks to boost growth. But be warned. The trades can also be a good way to lose large sums, given that exchange rates are prone to unpredictable corrections. That is what happened as the

yen began appreciating sharply in July,

wreaking havoc across global markets this week.

1. Why is it called a carry trade?

In finance speak, the “carry” of an asset is the return obtained from holding it. So, a carry trade involves buying a currency and “carrying” it until you make a profit.

2. How does it work?

The most common way to implement a carry trade is to borrow money in Country A, where interest rates are low, exchange it for the currency of Country B, where rates are high, and invest in bonds in Country B. Investors who do not want or are not able to invest in local-currency bonds can access carry returns through currency swaps and futures contracts, instruments that give payouts based on exchange-rate moves over time.

3. Are carry trades always risky?

No. But when they are, it can be big trouble. Economists have likened the carry trade to picking up pennies in front of a steam roller – the money is there for the taking, so long as you do not dally and get crushed. Just ask US hedge fund FX Concepts, which went bust in 2013 when it reacted slowly to decisions by central banks across the world to cut interest rates to virtually zero. Reversals of fortune in carry trades can be triggered by a tightening of monetary policy in the low-interest-rate currency, an unforeseen event that reduces the attractiveness of the target currency or simply a realisation in the market that the target currency has become detached from economic fundamentals.

4. Why is the yen so important?

Until the 1990s, carry trades were the realm of hedge-fund managers betting on obscure emerging-market currencies, and the term was little known in mainstream finance. Then the Bank of Japan (BOJ) cut its interest rates close to zero, and traders across the world realised they could make a profit borrowing in yen to buy US dollar-based assets. That blew up in 1998 when the Japanese currency rose 16 per cent versus the dollar in just one week, reversing years of profitability for carry-trade investors. The trade took another hit when the yen surged in 2007 against the dollar after the onset of the sub-prime mortgage crisis.

5. So what happened this week?

Carry trades funded by the yen became popular again in the last decade as volatility remained low and traders bet Japanese interest rates would remain at rock bottom. Then the

BOJ raised interest rates for the first time in 17 years

in March and hiked again in August. The second move, combined with hawkish rhetoric from the BOJ and fears of a US slowdown, sent the yen up sharply. Markets around the world saw heavy selling as traders rushed to sell assets such as stocks in order to unwind their yen-funded carry trades. Japan’s Nikkei 225 index plunged 12.4 per cent on Aug 5 and markets in Europe and North America suffered outsized losses. Markets recovered much of their losses on Aug 6, but the damage lingers.

6. Is it over yet?

The epic unwinding of the yen-funded carry trade that has reverberated through global markets may have further to go, analysts say. Mr James Malcolm, a UBS Japan macro strategist based, said on Aug 6 that the carry trade is only about 50 per cent unwound. He estimates the dollar-yen carry trade grew to at least US$500 billion (S$664 billion) at its peak and calculated that some US$200 billion of the carry trade has been unwound over the last two to three weeks. BLOOMBERG, REUTERS