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, and including 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. (For more on how leverage hurt the hedge funds during this period, read Hedge Fund Failures Illuminate Leverage Pitfalls.)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. (For more on this, see Why Housing Market Bubbles Pop.)
Example - Leverage Cuts Both Ways in Yen Carry TradeLet'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.
Borrow 100 million yen for one year at 0.50% per annum
Sell the borrowed amount and buy U.S. dollars at an exchange rate of 115 yen per dollar
Use this amount (approximately US$870,000) as 10% margin to acquire a portfolio of mortgage bonds paying 15%
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 = $11,745,000Total 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 = $8,265,000Total 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%