What is the carry trade that everyone is talking about?

The first market to react was Japan and its markets fell almost 13% (The markets recovered almost 11% today, but let us see what happened).

If I take a loan from a Japanese Bank at 1% interest and convert it to USD when USD/JPY is $140. I buy US assets like bonds with the dollars that will give me a 5% interest rate.

You will make good money in this trade & this is called carry trade.

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3 things can go wrong against you

1. USD/JPY currency depreciation i.e. it goes down from 140 to 130

2. If US Bond Yields go down, ie yield goes down from 5% to 4%

3. If Japan increases the loan rate, ie from 1% to 2%

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Assumptions

1. The amount loaned = 1,000,000 JPY
2. Loan interest rate = 1% ie 10,000 JPY per year
3. USDJPY = 140 USD
4. Equivalent USD = 1,000,000/140 = 7142.85 USD
5. Bond Yield in US = 5%
6. Interest income per year in USD = 5% of 7142.85 = 357.14
7. Interest income per year in JPY = 357.14*140 = 50000 JPY
8. Net profits per year in JPY = 50000–10000 = 40000 JPY

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Case 1: USDJPY goes from 140 to 130.

Step 7 will become 357.14*130 = 46428 JPY and net profits will be = 46428–10000 = 36428 JPY

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Case 2: US Bond yield is 4% instead of 5%

Step 6 will become, 4% of 7142.85 = 285.71

Interest income = 285.71*140 = 39999.96 JPY

Net income = 39999.96–10000 = 29999.96 JPY

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Case 3: JPY bond rate is 2% instead of 1%

Step 2 will become 2% of 1,000,000 = 20000 JPY per year, step 7 is the same so the new net income = 50000–20000 = 30000 JPY

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Imagine what would happen if all three of you went against you? Let us just recalculate and find out.

1. The amount loaned = 1,000,000 JPY
2. Loan interest rate = 2% ie 20,000 JPY per year
3. USDJPY = 140 USD
4. Equivalent USD = 1,000,000/140 = 7142.85 USD
5. Bond Yield in US = 4%
6. Interest income per year in USD = 4% of 7142.85 = 285.71
7. Interest income per year in JPY = 285.71*130 = 37142.3 JPY
8. Net profits per year in JPY = 37142.3–20000= 17142.3 JPY

We notice a 57.14% drop in profits if all three happen at the same time. Markets can be spooked even if there are changes in profits/arbitrage. Positions don’t need to go into a loss to create turmoil.

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