The yen carry trade and the importance of sound risk management

THE wild volatility in global markets caused by the unwinding of the yen carry trade may have subsided for now, but the aftershock may well be felt by investors for some time to come. The dramatic episode can serve as a timely reminder of the importance of sound risk management when making investment decisions – and the dangers of speculative leverage.

For years, the popular yen carry trade saw investors capitalise on a weak Japanese currency by borrowing money in yen at a low interest cost to invest in other currencies and assets offering greater yields – often riskier assets such as US tech stocks – to make a profit. Investors ploughed money into the trade following years of yen weakness and negative interest rates in Japan, and among many there was a strong expectation these conditions would continue.

The rationale was simple: If these investments performed well, yen interest costs stayed low, and the yen stayed the same (or weakened), returns were enhanced. However, there was always a significant risk that a sudden change in market sentiment, and a strengthened Japanese currency, could result in huge losses.