WILL THE CARRY TRADE COLLAPSE?

As the dollar sinks lower, and as the credit freeze continues, we wonder if the Yen carry trade can go on, business as usual. I think this party must end soon. The world is changing with the onset of the housing collapse in the the U.S. , foriegn investors are now shy of dollar denominated assets such as bonds and other paper promises. The reason is most feel they were burned by the U.S. banks when they were sold the pile of housing CDOs (collateralized debt obligations) that turned out to be worthless. Instead of being marked to market value, these toxic securities were marked to a computer model which turned out to be false. Fool me once, then shame on me, they say and will not trust again untill this storm of bad loans has passed. Many of these bad debts were sold to hedge funds. Many hedge funds make their living by buying and trading world currency. The favorite is the Yen carry trade.


Here's an example of a "yen carry trade": let's say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.