In-depth analysis of arbitrage trading: Why has the yen lost its appeal?

For decades, the yen has been the most favored funding currency for global carry trades, but this landscape is undergoing a fundamental shift. As the Bank of Japan (BOJ) continues to raise interest rates, the cost of borrowing yen is steadily increasing, narrowing arbitrage opportunities, and prompting some investors to look for alternative low-cost funding currencies.

On September 18, according to Bloomberg, The core dynamic is: Since the BOJ abandoned its negative interest rate policy in March 2024 and began a tightening cycle, the yen’s appeal as a funding currency has declined significantly. Meanwhile, Japanese authorities have repeatedly intervened in the market to support the weak yen since 2022, further increasing the currency risk exposure for carry traders. On July 31 of this year, Japan and the US jointly launched a historic foreign exchange intervention.

These changes are reshaping the direction of global carry trade flows. Currencies like the Swiss franc are gradually emerging as potential replacements for the yen as funding currencies. This not only signals a strategic shift but also indicates that a large-scale unwinding of carry trade positions could again trigger intense turmoil in global financial markets—the market turbulence during July to August 2024 has already served as a stark warning.

The Logic Behind Carry Trades

The core principle of carry trading is to borrow low-interest-rate currencies and invest the funds into higher-yielding assets, profiting from the spread between the two.

In financial terminology, an asset's "carry" refers to the net return after subtracting the funding costs from the gains investors earn by holding the asset. For instance, in a typical example:

Suppose an investor borrows 1 million yen at a 1% rate, converts it into US dollars, and invests in a US dollar asset with an annual yield of 4%. If the exchange rate remains stable, the investor earns a 3 percentage point spread. These positions are usually held for months or even years to maximize returns, but investors can also unwind positions quickly if market conditions change.

For investors unwilling or unable to directly purchase high-yield currency assets, carry trades can also be conducted via derivatives such as currency swaps and forward contracts.

Carry trades thrive when market volatility is low and interest rate differentials between countries are wide, which often results from diverging central bank policies—one side raising rates to curb inflation, while the other keeps rates low to spur growth.

Why the Yen Became the "King" of Funding Currencies for Carry Trades

The yen has long dominated as the primary funding currency for global carry trades, primarily due to Japan's extended and unusually aggressive ultra-low interest rate policy, unmatched by other major economies.

After Japan's asset price bubble burst in the early 1990s, the BOJ kept lowering rates, eventually dropping its policy rate to zero and even negative levels in a bid to revive economic growth. This made the cost of borrowing yen far lower than other major currencies, which strongly appealed to both institutional and retail investors.

However, since the BOJ announced its exit from negative rates in March 2024 and started raising borrowing costs, the yen’s status as a prime funding currency has started to wobble. Higher interest rates mean higher costs for borrowing yen, reducing potential returns from carry trades. Meanwhile, repeated currency interventions by Japanese authorities have increased exchange rate volatility risk for carry traders.

When choosing a funding currency, traders must weigh both borrowing costs and exchange rate risk. These two dimensions together—the so-called "carry-to-risk ratio" in the industry—are key considerations.

The Swiss National Bank (SNB) keeps its policy rate at zero and stands ready to intervene to curb excessive franc appreciation, providing carry traders with a relatively stable funding environment.

Risks of Carry Trades: "Picking Up Pennies in Front of a Steamroller"

Economists liken carry trades to "picking up pennies in front of a steamroller"—the returns are within reach, but hesitation can lead to being crushed.

The greatest risk in carry trades is exchange rate volatility. To profit, the interest spread must be sufficient to offset losses from currency movements. Yet exchange rate swings often far exceed interest spreads, easily wiping out all earnings.

Returning to the earlier example: suppose after a year the value of the US dollar asset rises to $10,400, but during that time the yen appreciates against the dollar to 80. After converting back, only 822,000 yen remains—after deducting 1% borrowing interest, this is lower than the original 1 million yen, resulting in a loss for the investor.

For leveraged investors, the risk is magnified. If losses trigger margin calls, investors are forced to sell assets to raise cash, which can spur further declines in asset prices, deepening losses, and triggering a vicious cycle of forced sales—potentially impacting broader markets. For this reason, carry trades are often regarded as a key source of global financial instability and crisis contagion.

Scale of Carry Trades: Difficult to Quantify Accurately

The exact scale of carry trading is difficult to measure because the trades are diverse and market data rarely reveals individual investor strategies.

Researchers at the Bank for International Settlements (BIS) attempted a rough estimate in a September 2024 report, finding that about 200 trillion yen (around $1.3 trillion) in net yen supply is absorbed by non-bank market participants. This figure includes overseas investors hedging yen-denominated assets and speculators possibly borrowing yen for carry trades, but not all is directly related to carry strategies.

Data from the US Commodity Futures Trading Commission (CFTC) offers a narrower but more up-to-date perspective: Since the end of June, hedge funds have slashed their net short yen futures and options positions by nearly two-thirds, after previously hitting a 19-year high. Net short positions serve as a proxy for speculative carry trading, as these strategies essentially bet on the depreciation of funding currencies. However, they only capture a small fraction of the global forex market, which has a daily turnover of $9.6 trillion.

The 2024 Warning: How Massive Carry Trade Unwinds Triggered Market Turbulence

The shockwaves from massive carry trade unwinding were vividly evident between July and August 2024.

As the BOJ hiked rates and Governor Kazuo Ueda signaled further tightening, the prospect of rising borrowing costs in Japan forced carry traders to rapidly unwind positions. This drove a sharp yen appreciation and hammered popular carry targets—most notably the Mexican peso. Japanese equities also came under pressure as yen-denominated positions were closed, worsening overall market volatility.

The data tell a compelling story: From July 31 to August 5, the yen rose by about 8% against the US dollar; the Mexican peso lost around 13% against the yen; and the Nikkei 225 crashed 19% over the same period.

This episode confirms the systemic risk of carry trades: when a large number of investors exit positions simultaneously, flows can trigger cross-market chain reactions in a short time, affecting both bond and equity markets. With yen funding costs on the rise, awareness of the next potential wave of carry unwinding persists in the market.