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Economic Trends

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The Yen Carry Trade

The yen carry trade carries on. International investors borrow yen at extremely low Japanese interest rates and invest (carry) the funds in higher yielding, foreign-currency assets for a profit. The Australian dollar, the New Zealand dollar, and the U.K. pound are frequent target currencies for the yen carry trade. Carry-trade investors typically remain exposed to foreign-exchange risk. Consequently, many observers fear that if the Bank of Japan raises interest rates, the carry trade might unwind rapidly with repercussions in global currency markets.

Persistent carry-trade profits seem an economic anomaly. Suppose, for example, that an investor borrows Japanese yen at a low interest rate for three months and places it in a higher-yielding Australian three-month instrument. All else constant, this arbitrage should bid up Japanese interest rates and bid down Australian interest rates until the profit opportunity disappears. The process, however, is even more complicated. Arbitrage also alters two exchange rates—the spot Japanese yen-Australian dollar rate and the rate three months hence. The spot yen will depreciate as investors convert their borrowed yen to dollars, and yen will appreciate three months hence as investors go back into yen to repay their loans. Arbitrage will wipe out any profit, and any persistent interest-rate differential will be lost in currency conversions. Or so theory suggests.

But other things are not necessarily constant. Empirically, this pattern has not happened, as Federal Reserve Bank of San Francisco economist Michele Cavallo points out. The currencies of countries with low interest rates have tended to depreciate, or to not appreciate sufficiently to offset arbitrage opportunities. This fuels the carry trade and also the fear that a Japanese interest-rate hike might rapidly reverse the yen carry trade.


Economic Trends is published by the Research Department of the Federal Reserve Bank of Cleveland.

Views stated in Economic Trends are those of individuals in the Research Department and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. Materials may be reprinted provided that the source is credited.

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