0.25% in July 2006 and subsequently increased to 0.5% in February 2007. The rise in interest rates has increased the borrowing cost of yen carry traders. This coupled with the recent appreciation in the yen has left two exit routes for traders - book losses by squaring positions or hedge the trade using swaps.
India and Yen carry trades
Several funds investing in India have raised money from the Japanese market, for example, Fidelity Investments, Deutsche Asset Management and several others. Japanese money has also entered Indian markets through Japanese and other investors who are borrowing yen to invest in Indian asset classes, and corporates borrowing yen denominated funds.
Excessive speculative funds in the economy, caused in part by yen carry trades, have raised the inflation rate to 6.7% and, may lead to overheating of the economy.
Unwinding of Yen Carry Trades
The recent appreciation in the yen will compel traders to sell their assets and repay borrowed yen, leading to a fall in asset prices and further strengthening of the yen.
In October 1998, a mass unwinding of yen carry trades lead to excessive volatility in financial markets. During that period the yen had been depreciating over three years. Mid 1998, the yen began to appreciate finally leading to a mass selling of high-yielding assets and underlying currencies to repay yen denominated borrowings. This led to a sharp appreciation in the yen (due to bulk buying of yen for repayments) and also led to a steep fall in high-yielding asset prices (due to bulk selling). The Federal Reserve was forced to reduce the fed rate twice to bring liquidity in the markets.
Currently, hedge funds have low exposure to carry trades as against in 1998, when yen carry trade was a very popular strategy for hedge funds. Overall, the current quantum of yen carry trades seem lower than those during the 1998 period, even then, a possible future mass unwinding of yen carry trades would most definitely create volatility in the markets. For an Indian investor, this is just one of the unexpected effects of increasing globalisation!
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