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The Credit Crisis And The Carry Trade

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By 22.10.2012

Broadly speaking, the term "carry trade" means borrowing at a low interest rate and investing in an asset that provides a higher rate of return. For example, assume that you can borrow $20,000 at an interest rate of 3% for one year; further assume that you invest the borrowed proceeds in a certificate of deposit that pays 6% for one year. After a year, your carry trade has earned you $600, or the difference between the return on your investment and the interest paid times the amount borrowed.

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Of course, in the real world, opportunities like these rarely exist because the cost of borrowing funds is usually significantly higher than interest earned on deposits. But what if an investor wishes to invest low-cost funds in an asset that promises spectacular returns, albeit with a much greater degree of risk? In this case, we are referring to the currency, or forex, markets, where carry trades quickly became one of the most important strategies. These trades allowed some traders to rake in big profits, but they also played a part in the credit crisis that struck world economic systems in 2008.

A New Millennium for Carry Trades

In the 2000s, the term "carry trade" became synonymous with the "yen carry trade," which involved borrowing in the Japanese yen and investing the proceeds in virtually any asset class that promised a higher rate of return. The Japanese yen became a favored currency for the borrowing part of the carry trade because of the near-zero interest rates in Japan for much of this period. By early 2007, it was estimated that about U.S.$1 trillion had been invested in the yen carry trade.

Carry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. This was the case in the period from 2003 until the summer of 2007, when interest rates in a number of nations were at their lowest levels in decades, while demand surged for relatively risky assets such as commodities and emerging markets.

The unusual appetite for risk during this period could be gauged by the abnormally low level of volatility in the U.S. stock market (as measured by the CBOE Volatility Index or VIX), as well as by the low-risk premiums that investors were willing to accept (one measure of which was the historically low spreads of high-yield bonds and emerging market debt to U.S. government Treasury Bills (T-Bills).

Carry trades work on the premise that changes in the financial environment will occur gradually, allowing the investor or speculator ample time to close out the trade and lock in profits. But if the environment changes abruptly, investors and speculators could be forced to close their carry trades as expeditiously as possible. Unfortunately, such a reversal of innumerable carry trades can have unexpected and potentially devastating consequences for the global economy.

Why the Carry Trade Works

As noted earlier, during the boom years of 2003-2007, there was large-scale borrowing of Japanese yen by investors and speculators. The borrowed yen was then sold and invested in a variety of assets, ranging from higher-yielding currencies, such as the euro, to U.S. subprime mortgages and real estate, as well as in volatile assets such as commodities and emerging market stocks and bonds.

In order to get more bang for their buck, large investors such as hedge funds used a substantial degree of leverage in order to magnify returns. But leverage is a double-edged sword - just as it can enhance returns when markets are booming, it can also amplify losses when asset prices are sliding.

As the carry trade gained momentum, a virtuous circle developed, whereby borrowed currencies such as the yen steadily depreciated, while the demand for risky assets pushed their prices higher.

It is important to note that currency risk in a carry trade is seldom, if ever, hedged. This meant that the carry trade worked like a charm as long as the yen was depreciating, and mortgage and commodity portfolios were providing double-digit returns. Scant attention was paid to early warning signs such as the looming slowdown in the U.S. housing market, which peaked in the summer of 2006 and then commenced its long multiyear slide.

Example - Leverage Cuts Both Ways in Yen Carry Trade

Let's run through an example of a yen carry trade to see what can happen when the market is booming and when it goes bust.

  1. Borrow 100 million yen for one year at 0.50% per annum.

  2. Sell the borrowed amount and buy U.S. dollars at an exchange rate of 115 yen per dollar.

  3. Use this amount (approximately US$870,000) as 10% margin to acquire a portfolio of mortgage bonds paying 15%.

  4. The size of the mortgage bond portfolio is therefore $8.7 million (i.e. $870,000 is used as 10% margin, and the remaining 90%, or $7.83 million, is borrowed at 5%).

After one year, assume the entire portfolio is liquidated and the yen loan is repaid. In this case, one of two things might occur:

Scenario 1 (Boom Times)
Assume the yen has depreciated to 120, and that the mortgage bond portfolio has appreciated by 20%.

Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio

= $1,305,000 + $10,440,000 = $11,745,000

Total Outflows = Margin Loan ($7.83 million principal + 5% interest) + Yen Loan (principal + 0.50% interest)

= $8,221,500 + 100,500,000 yen

= $8,221,500 + $837,500 = $9,059,000

Overall Profit = $2,686,000

Return on Investment = $2,686,000 / $870,000 = 310%

Scenario 2 (Boom Turns to Bust)
Assume the yen has appreciated to 100, and that the mortgage bond portfolio has depreciated by 20%.

Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio

= $1,305,000 + $6,960,000 = $8,265,000

Total Outflows = Margin Loan ($7.83 million principal + 5% interest) + Yen Loan (principal + 0.50% interest)

= $8,221,500 + 100,500,000 yen

= $8,221,500 + $1,005,000 = $9,226,500

Overall Loss = $961,500

Return on Investment = -$961,500 / $870,000 = -110%

The Great Unraveling of the Yen Carry Trade

The yen carry trade became all the rage among investors and speculators, but by 2006, some experts began warning of the dangers that could arise if and when these carry trades were reversed or "unwound." These warnings went unheeded.

The global credit crunch that developed from August 2007 led to the gradual unraveling of the yen carry trade. A little over a year later, as the collapse of Lehman Brothers and the U.S. government rescue of AIG sent shockwaves through the global financial system, the unwinding of the yen carry trade commenced in earnest.

Speculators began to be hit with margin calls as prices of practically every asset began sliding. To meet these margin calls, assets had to be sold, putting even more downward pressure on their prices. As credit conditions tightened dramatically, banks began calling in the loans, many of which were yen-denominated. Speculators not only had to sell their investments at fire-sale prices, but also had to repay their yen loans even as the yen was surging. Repatriation of yen made the currency even stronger. In addition, the interest rate advantage enjoyed by higher-yielding currencies began to dwindle as a number of countries slashed interest rates to stimulate their economies.

The unwinding of the gigantic yen carry trade caused the Japanese currency to surge against major currencies. The yen rose as much as 29% against the euro in 2008. By February 2009, it had gained 19% against the U.S. dollar.

Carry Trade Casualties

The carry trade pushes asset prices to unsustainably high levels when the global economy is expanding. But rapid and unexpected changes in the financial environment can result in the virtuous circle quickly turning into a vicious one. In 2008, global financial markets suffered record declines after being hit by a deadly combination of slowing economic growth, an unprecedented credit crisis and a near-total collapse of consumer and investor confidence.

Large-scale unwinding of the carry trade can also result in plunging asset prices, especially under tight credit conditions, as speculators resort to panic liquidation and rush to get out of trading positions at any price. Numerous hedge funds and trading houses had to contend with huge losses in the aftermath of the unwinding of the yen carry trade.

Banks may also be affected if their borrowers are unable to repay their loans in full. But as the events of 2008 proved, the broad decline in asset prices had a much larger impact on their balance sheets. In 2008, financial institutions around the world recorded close to $1 trillion in charge-offs and write-downs related to U.S. mortgage assets.

The global economy was also severely affected, as the collapse in asset prices affected consumer confidence and business sentiment, and exacerbated an economic slowdown. Nations whose currencies were heavily involved in the carry trade (such as Japan) would also face economic headwinds, as an unusually strong domestic currency can render exports uncompetitive.

The Bottom Line

Carry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. When boom times turn to bust, however, these trades have proved devastating for traders and for the broader markets.

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