Detailed Explanation of Carry Trade: Why Has the Japanese Yen Lost Its Appeal?
For decades, the Japanese yen has been the most favored funding currency for global carry trades, but this pattern is undergoing a fundamental shift. As the Bank of Japan (BOJ) continues to raise interest rates, the cost of borrowing yen is rising, arbitrage opportunities are narrowing, and some investors have begun to turn their attention to other low-cost funding currencies.
On September 18, Bloomberg reported that the key development is that the attractiveness of the yen as a funding currency has significantly declined since the Bank of Japan abandoned its negative interest rate policy and began a rate hike cycle in March 2024. Meanwhile, Japanese authorities have intervened in the market multiple times since 2022 to support the weak yen, further increasing the exchange rate risk exposure of carry traders. On July 31 this year, Japan and the United States also jointly carried out a historic foreign exchange market intervention.
These changes are reshaping the flow of funds in global arbitrage trading. Currencies such as the Swiss franc are gradually emerging as potential alternative funding currencies to the Japanese yen. This not only signifies strategic adjustments but also foreshadows a potential for severe market volatility should arbitrage trading be unwound on a large scale—the market turmoil of July and August 2024 served as a stark warning.
The operating logic of arbitrage trading
The core principle of carry trade is to borrow low-interest currency and invest the funds in high-yield assets to profit from the interest rate differential between the two.
In financial terminology, the "carry" of an asset refers to the net return an investor receives from holding that asset, minus financing costs. Let's take a typical example:
Suppose an investor borrows 1 million yen at a 1% interest rate, converts it into US dollars, and invests it in a US dollar asset with an annual yield of 4%. If the exchange rate remains stable, the investor can earn a 3% interest rate differential. Such positions are typically held for months or even years to maximize returns, but investors can also quickly close them if market conditions change.
For investors who are unwilling or unable to directly purchase high-yield currency assets, they can also participate in arbitrage trading through derivative instruments such as currency swaps and forward contracts.
Arbitrage trading is most prevalent when market volatility is low and interest rate differentials between countries are large . This often stems from the divergence in monetary policies among central banks – one side raises interest rates to curb inflation, while the other maintains low interest rates to stimulate economic growth.
Why has the Japanese yen become the "king" of carry trades and a leading funding currency?
The Japanese yen has long held the top position as the funding currency for global carry trades, which stems from the fact that Japan's ultra-low interest rate policy has been unparalleled in its duration and intensity among major economies.
Following the bursting of Japan's asset price bubble in the early 1990s, the Bank of Japan persistently suppressed interest rates, eventually lowering the policy rate to zero and even negative territory in an effort to revive economic growth. This made borrowing yen far less expensive than other major currencies, making it highly attractive to both institutional and retail investors.
However, since the Bank of Japan announced its exit from negative interest rate policy and began raising borrowing costs in March 2024, the yen's status as a funding currency has begun to waver. Interest rate hikes mean higher costs for borrowing yen, thus narrowing the potential returns for carry trades. At the same time, repeated interventions in the foreign exchange market by Japanese authorities have also exposed carry traders to higher exchange rate volatility risks.
When choosing a funding currency, traders must consider not only borrowing costs but also the risk of exchange rate fluctuations. These two dimensions—what the industry calls the "carry-to-risk ratio"—must be considered together .
The Swiss National Bank (SNB) has kept its policy rate at zero and is prepared to intervene to curb excessive appreciation of the Swiss franc, providing a relatively stable funding environment for arbitrage traders.
The risks of arbitrage trading: "Picking up coins in front of a steamroller"
Economists liken arbitrage trading to "picking up coins in front of a steamroller"—profits are within reach, but hesitation could lead to being crushed.
The biggest risk in arbitrage trading lies in exchange rate fluctuations. To profit, the interest rate differential must be sufficient to cover losses from exchange rate changes. However, exchange rate fluctuations often far exceed the interest rate differential, quickly wiping out all gains.
Taking the aforementioned case as an example: Suppose that after one year, the value of the US dollar asset increases to US$10,400, but at the same time the Japanese yen appreciates to 80 against the US dollar. After converting back to Japanese yen, the asset is only worth 822,000 yen. After deducting the 1% loan interest, this is less than the initial borrowed 1 million yen, and the investor therefore incurs a loss.
For investors using leverage, the risks are amplified. Once losses trigger margin calls, investors are forced to sell assets to raise cash, potentially triggering a vicious cycle of falling asset prices, further losses, and further forced selling, impacting a wider market. For this reason, arbitrage trading is often considered a significant source of global financial vulnerability and crisis transmission.
The scale of arbitrage trading: difficult to quantify precisely.
The exact size of arbitrage trading is difficult to measure because such trades take many forms and market data often fails to reveal the specific strategies of individual investors.
A September 2024 report by researchers at the Bank for International Settlements (BIS) attempted to estimate the size of yen carry trades, finding that approximately 200 trillion yen (about US$1.3 trillion) of net yen supply was absorbed by non-bank market participants. This figure includes overseas investors hedging yen-denominated assets and speculators who may borrow yen for carry trades, and is not entirely directly related to carry trade strategies.
Data from the U.S. Commodity Futures Trading Commission (CFTC) offers a more limited but timely perspective: hedge funds have reduced their net short positions in yen futures and options by nearly two-thirds since the end of June , after these bearish bets reached their highest level in 19 years. Net short positions can serve as a proxy for speculative arbitrage trading, as arbitrage strategies are essentially betting on the depreciation of funding currencies. However, this only captures a small fraction of arbitrage activity in the global foreign exchange market, which boasts a daily turnover of $9.6 trillion.
A warning from 2024: How closing out arbitrage trades can trigger market turmoil.
The impact of large-scale liquidation of arbitrage trades on financial markets was fully demonstrated between July and August 2024.
Following the Bank of Japan's interest rate hike and Governor Kazuo Ueda's hints at further monetary tightening, expectations of rising borrowing costs in Japan prompted carry traders to quickly unwind their positions. This process drove a sharp appreciation of the yen and severely impacted popular carry trade currencies—the Mexican peso being the hardest hit. Japanese stocks also came under pressure from the unwinding of yen-denominated positions, exacerbating overall market volatility.
The specific data is alarming: between July 31 and August 5, the Japanese yen appreciated by about 8% against the US dollar; the Mexican peso depreciated by about 13% against the yen; and the Nikkei 225 index plummeted by 19% during this period.
This incident once again demonstrates the systemic risks of arbitrage trading: when a large number of investors simultaneously close their positions, the flow of funds can trigger a chain reaction across markets in a short period of time, with neither the bond nor the stock market spared. As the cost of yen financing continues to rise, market vigilance regarding the next potential wave of liquidations has never dissipated.
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