What is carry trade and how does Bank of Japan’s rate hike affect it?

Hikes in the interest rate will cause the spread between the Japanese yen and higher-yielding currencies to diminish.

The Bank of Japan hiked interest rates on July 31, sending the Japanese indices into a tailspin and the global markets roiling.

The Japanese Central Bank first hiked interest rates after 17 years on March 19, for the first time since 2007. The BoJ announced that it was raising its short-term policy rate from -0.1 percent to between 0 and 0.1 percent.

While the move is seen benefitting the country’s economy, it is expected to have an adverse impact on carry trade. Through this explainer, we look at what a carry trade is and how a strong yen can upset the calculations of traders who use this strategy.

Also Read | Bank of Japan scraps negative interest rate

What is a carry trade?

It is a strategy that involves borrowing money in a currency that has a low-interest rate and investing it in asset classes that offer a higher rate of return. While this strategy is popular with forex traders, it is also used by fund managers who deal in equities and commodities, and bonds.

In a conversation with Moneycontrol, Jigar Trivedi, senior commodities analyst, Reliance Securities, offers an example on how a simple carry trade strategy could be used.

Assume an investor wants to invest his money in a fixed deposit. The banks in Country A offers 5 percent to depositors, and those in Country B offer 8 percent.

However, the investor needs to borrow money to invest. The banks in Country A charge 6 percent to borrowers, and Country B’s banks charge 9 percent.

The investor decides to borrow money from Country A’s banks in their local currency to invest in Country B. He then converts that money into the local currency of country B and deposits that in the bank.

Assuming there are no currency fluctuations, the investors earns a good return by taking advantage of the interest rate differential.

Does it only work with currencies?

While used primarily with forex, the strategy is not limited to currencies only. Traders can also employ the strategy by borrowing money in a currency with lower interest rates, such as the Japanese yen, and deploying the capital in various asset classes such as currencies, bonds, and equities that offer higher returns.

Interest rates in Japan have been zero for a long time, while interest rates on government bonds in India offer more than 7 percent. For a fund manager borrowing in yen and investing in Indian government bonds, will the profit margin be as high as 7 percent plus?

Not really. The fund manager looking to do a carry trade in Indian government bonds will first have to convert the yen to dollars. There is a cost to this conversion. The fund manager will then have to convert the dollars to rupees. There is a cost to that as well. Then the fund manager will have to buy hedges against a possible devaluation in the rupee.

Why is that?

Because if the rupee weakens, you will need more rupees to buy the same amount of dollars.

I get it. So will the fund manager also have to buy a similar hedge for possible weakening of the dollar?

You are right. On the return leg, if the dollar weakens against the yen, or conversely the yen strengthens against the dollar, you will need more dollars to repay the same amount of yen.

Please explain with an example?

If one dollar equals Rs 80 at the time of investment and the rupee weakens to Rs 85 against the dollar, it means you will now need Rs 85 to return the dollar which you had borrowed for Rs 80. Similarly, if the yen was 140 to the dollar at the time of initiating the trade and strengthens to 130, the fund manager needs more dollars to repay the loan.

Also Read | Bank of Japan reverses its ultra-loose monetary policy; how will this impact bonds, equities, currencies?

Coming back to the point you were making about hedging costs and profit margins…

Yes. The cost of converting the currency and buying hedges as a guard against currency fluctuations reduces the profit margins. So it won’t be as high as 7 percent for a carry trade between the yen and Indian government bonds.

How does the Bank of Japan’s decision affect traders?

The effect on the traders who use the yen in their carry trade strategy is twofold.

First, the borrowing of the yen becomes more expensive due to higher interest rates. Unless the return on the other leg of the transaction too increases, the profit margin will shrink.

Second, higher interest rates could attract more foreign inflows into Japan, further strengthening the currency. This could increase losses for the traders, as repaying the loan could become more expensive, given the appreciation in the value of the yen.

How will further rate hikes from BoJ impact traders?

If the Japanese central bank continues to raise interest rates, carry trades might lose their appeal, say experts. Hikes in the interest rate will cause the spread between the Japanese yen and higher-yielding currencies to diminish.

“Traders may be less willing to borrow yen at high interest rates to invest in currencies with only marginally higher yields. They might reevaluate their risk-reward calculations and consider alternative currency pairs or trading approaches in response to the changing interest rate environment,” explained Aamir Makda, Commodity & Currency Analyst, Choice Equity Broking.

For now, the consensus among currency analysts is that the Japanese yen still remains an attractive option, and has retained its safe haven status. But if the hikes continue, traders might forgo the yen and switch to currencies with lower interest rates or employ different trading strategies.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.