Stock Markets and the Japanese Carry Trade

So what is the “Carry Trade” about and what does it have to do with the turmoil in the global markets?

To understand this phenomenon we have to learn two terms:
1. Carry trade and …
2. Margin call.

First, the “carry trade.” This refers to the practice of borrowing money at a low rate and investing it at a higher rate. As you all learned by reading your Wall Street Journal, interest rates in Japan have been remarkably low; virtually zero. Enterprising speculators have been borrowing money in Japan and investing it in securities that paid more. These could be as low risk as US government bonds or as high risk as Chinese stocks.

If you can borrow Japanese yen at, say, 0.5% and buy US government bonds at, say, 4.5% you can make a fortune. And if you want to take more risk and invest the Japanese loan in the Chinese stock market which doubled last year, you could become very, very rich indeed.

This worked very well for some years. But there is something that can go wrong.

In fact, several somethings.

The first thing that can go wrong is that your investment is poorly chosen and its value declines.

The second thing that can go wrong is that the value of the currency you borrowed can rise. That means that your investment in those US Government bonds may not be enough to pay off the loan you made in Japanese yen.

And those two things happened at roughly the same time.

After rising like a skyrocket during 2006, the Chinese stock market declined by about 10% in a single day. That is enough to spook a speculator.

Then the Japanese yen began rising relative to other currencies; making it more expensive to pay off those Japanese loans.

And that’s where the margin calls came in. Banks that lend you money like to know that you can pay it back. They check on their collateral. And when they are dealing with speculators they check on their collateral daily, if not hourly. If the banks see that you may have trouble paying them back, they ask you to come up with extra cash.

And here comes the “spillover effect.” If you can’t sell the security that is giving you problems but are told that you have to raise cash, you sell whatever can be sold readily. And if that happens to be a portfolio of Blue Chip stocks that you own, well, that’s what you sell.

And if that causes the DJIA to drop 500 points in a single day, well, you do what you have to do.

The lesson for us all is to be aware of all the risks we’re taking, even the ones that you don’t see coming.