The dramatic move of the Japanese Yen (JPY) in recent times is being sold everywhere as the ‘liquidation of carry trades’. This suggests that speculative investors have so far taken short positions in the JPY, which they financed with the low JPY interest rates, in order to invest the funds thus obtained in higher-yielding currencies. These speculative investors were thus aiming to reap a safe interest rate advantage, according to this story, notes Ulrich Leuchtmann, Head of FX and Commodities Research at Commerzbank.
Carry trade liquidation makes little sense
“As a metaphor, this story is not bad at all. It only becomes misleading if you take it too literally and calculate, for example, what percentage of the carry trade has already been liquidated. Why? Because a carry trade described this way makes little sense. Take the example of USD/JPY.”
“In mid-July, the trough of 1-year implied volatility was around 9%, the USD interest rate around 5.2% and the JPY interest rate around 0.25%. This means that while it was possible to earn almost 5% annually on a USD/JPY carry trade, the market expected the pair to fluctuate by an average of 9% over the next 12 months.”
“The fact that exchange rate movements appear excessive to the layman, that it may seem implausible, for example, that a 25 basis point rise in JPY interest rates would justify a USD/JPY decline of more than 10 large digits, is of course due to a dynamic that economists understand quite well. As early as the 1970s, Rudi Dornbusch explained with his overfitting model why this must be so. ‘Liquidation of carry trades’ appears nowhere in this explanation.”
Source: Fx Street
I am Joshua Winder, a senior-level journalist and editor at World Stock Market. I specialize in covering news related to the stock market and economic trends. With more than 8 years of experience in this field, I have become an expert in financial reporting.
