Academic journal article Journal of Business and Behavior Sciences

Does Unwinding Carry Trade Lead to Profitable Reverse Carry Trade? the Case of Yen

Academic journal article Journal of Business and Behavior Sciences

Does Unwinding Carry Trade Lead to Profitable Reverse Carry Trade? the Case of Yen

Article excerpt


The objective of the paper is to investigate whether the reverse yen carry trade would result in positive returns over one-month, three-month, and one-year investment horizons, and how they are related to two explanatory variables: VIX and interest rate differences. The reverse yen carry trade is the exact inversion of process of the yen carry trade. Interest rate in Japan has been consistently lower than in the U.S., and the interest rate differential between the two has been prompting a common short-term speculation called yen carry trade that involves borrowing in yen in at a low interest rate, selling the yen for dollar to invest in the U.S. higher-yielding assets. Because UIP predicts that the currency with the higher interest rate will depreciate against the currency with the lower rate, the carry trader is actually betting against UIP (Colavecchio, 2008). The investor in yen carry trade seeks steady and small carry trade returns from the interest rate differential betting that dollar (i.e., the higher-yielding target currency) would appreciate rather than depreciate, while yen would depreciate rather than appreciate due to a large volume of carry trades that sell yen to buy dollar. The yen carry trade relies on relative stability of the higher U.S. short-term interest rates and a favorable exchange rate movement for dollar. As long as the dollar appreciates against the yen, the yen carry trade would result in profit because the investment proceeds in dollar would be converted into more yen.

The danger of the yen carry trade is that a large sudden loss is possible when the dollar depreciates and the yen appreciates consistent with the prediction of the UIP. To the extent that the yen carry trade investors would suffer loss (and unwind investment positions) as the yen appreciates enough to offset the interest differential earned on the dollar investment, investors who reversed the entire process should enjoy profit by borrowing dollar before converting into yen to invest in yen that appreciated despite low interest rate. Reverse yen carry trade is economically sensible to the extent that the rate of appreciation in yen exceeds the interest rate differential between dollar and yen.

According to Colavecchio (2008), carry trades tend to be pursued only when the interest differential is wide enough to compensate for the foreign exchange risk being taken, and she confirms that an increase in exchange rate volatility and a decrease in expected interest rate differentials lead to a higher probability of carry trade unwinding. She also found that in periods of high volatility of exchange rates, the risk to carry trade increases.

The CBOE Volatility Index® (VIX®) is a key measure of investor sentiment and market expectations of near-term volatility conveyed by S&P 500 stock index option prices. When VIX increases, it is less attractive to engage in reverse carry trade, and hence reverse carry traders will require higher expected returns on it. Jung and Black (2016) found that the yen carry trade was a money-losing game after the 2008 global financial crisis due to a narrower interest rate differential between Japan and the U.S. and higher exchange rate risk driven by higher market volatility.


Fama (1984) found an inconsistency prevalent in short-term foreign exchange market that currencies with high yield tend to appreciate and the low yield currencies depreciate: the opposite to the prediction of UIP, and he called it "forward premium puzzle". Despite many academic research attempts to explain the puzzle, it still remains unresolved, thus spurring short-term investors to exploit arbitrage profit opportunities by attempting currency carry trade.

Flood and Rose (2002) tested for uncovered interest parity (UIP) using daily data for 23 developing and developed countries during the crisis-strewn 1990s. Their study found that UIP works better on average in the 1990s than in previous and UIP systematically failed for fixed and flexible exchange rate countries than for crisis countries implying that high yield currencies appreciate while those low yield currencies appreciate as opposed to the prediction of the UIP. …

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