Current Affair 1:

How Does Yen Carry Trade Work?

Borrow Japanese yen at a low interest rate: Investors borrow Japanese yen, which typically has a very low interest rate, often close to zero or even negative.

Convert the borrowed yen into a higher-yielding currency: The borrowed yen is then converted into a currency that has a higher interest rate, such as the US dollar, the Australian dollar, or the New Zealand dollar.

Invest in higher-yielding assets: The converted funds are then used to invest in higher-yielding assets, such as government bonds, corporate bonds, or other financial instruments denominated in the higher-yielding currency.

Profit from the interest rate differential: The investor earns the higher interest rate on the invested assets, while only paying the lower interest rate on the borrowed yen. The difference between the two interest rates is the potential profit from the carry trade.

Now the news is:

Japan's currency has appreciated by 10 percent against the dollar in just over 3 weeks, partly driven by the Bank of Japan's (BoJ's) 15-basis points rate hike to 0.25 percent last week.

Just understand why an increase in interest hikes led to a fall in the global stock market.

I want to explain first, why higher interest rates lead to currency appreciation.

Higher interest rates can increase a country's currency value by attracting foreign investment. When interest rates increase, it becomes more expensive to borrow and more rewarding to save, which can reduce demand and slow inflation. This can also make a country's assets, like bonds and savings accounts, more attractive to foreign investors. When foreign investors invest in a country, they often need to convert their currency into the local currency, which increases demand for that currency. This increased demand causes the value of the currency to go up, which is known as currency appreciation.

Now when currency appreciates: For example, here yen:

1 dollar = 50 yen (just as an example)

Now after appreciation:

1 dollar: 25 Yen.

So, what exactly will happen? If someone has a dollar and wants to convert it into yen, he will get less yen than before. So, now he has to pay 2 dollars to get 50 yen (before it was only 1 dollar). Fear of further appreciation will force people to sell dollars and repay yen to Japanese banks as soon as possible.

Result: Turbulence in the market (more dollars in the market, their rupee will fall, which can lead to sudden and significant movements in exchange rates.). They will try to sell their stocks (as they fear further appreciation, they have to pay more dollars to return yen to Japanese bank)

Hope you understand why the sudden increase in interest rates by the Bank of Japan is creating problems in the world economy.

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