Lending from Japanese Yen to US Dollars — The Profit Logic and Risk Management of Carry Trade

Why Has Carry Trade Become a Focus in Capital Markets?

Since 2022, when global central banks began raising interest rates, carry trade has gradually become one of the core strategies for investment institutions and international speculators. This type of arbitrage involves exploiting interest rate differentials between financial instruments, essentially borrowing in low-interest currencies to invest in high-yield assets, thereby earning the interest spread.

Taking Taiwan as an example, when the Federal Reserve raised rates to 5% and the Taiwan Central Bank adjusted its rates more conservatively, borrowing TWD at 2% and converting to USD deposits at 5% could lock in a 3% interest differential. In 2022, the TWD/USD exchange rate was about 1:29, and by 2024, it had moved to 1:32.6, meaning not only can you earn more interest, but currency appreciation also brings additional gains.

However, not all currencies in rate-hiking countries will appreciate. Historically, Argentina responded to its debt crisis with aggressive rate hikes approaching 100%, yet the exchange rate still depreciated by 30% on the day of policy announcement, illustrating that the complexities involved in carry trades far exceed surface appearances.

The Three Major Risks of Carry Trade and Their Hedging Mechanisms

To profit steadily from carry trades, one must first understand the hidden risk factors:

1. Exchange Rate Risk

This is the most direct risk. Although rate hikes are often associated with currency appreciation, political factors, deteriorating economic fundamentals, capital flight, and other issues can cause the opposite. High leverage amplifies this risk.

2. Interest Rate Risk

Narrowing or even reversing the interest spread poses significant hidden dangers. For example, Taiwan’s insurance industry previously sold fixed-income policies with 6%-8% payouts when deposit rates were 10%-13%. Now, deposit rates have fallen to 1%-2%, turning these policies into a heavy burden for insurers. Similar situations occur in mortgage arbitrage—when mortgage rates rise or rental income declines, the expected interest advantage can evaporate.

3. Liquidity Risk

Not all financial products can be quickly liquidated. Some assets bought at 100 units might only be sellable at 90 units. Long-term contracts like insurance policies may have surrender restrictions, forcing investors to hold losing positions for extended periods.

Practical Hedging Approaches

Common hedging methods involve using inverse or opposite financial instruments to lock in risks. For example, a Taiwanese factory receiving a USD 1 million order with delivery in a year can use forward FX contracts (SWAPs) to lock in exchange rates. The cost is sacrificing potential gains from currency appreciation and paying hedging costs. In practice, most investors only hedge partially—mainly to mitigate uncontrollable risks like market gaps during holidays—not fully lock in all risks.

Yen Carry Trade: The Largest Global Arbitrage Mechanism

The most famous carry trade example globally involves borrowing in Japanese yen. Japan has become a “financing factory” for various funds due to its unique combination of political stability, relatively strong exchange rate, extremely low and easily accessible interest rates. The Bank of Japan’s long-standing zero or negative interest rate policy has increased international capital’s incentive to use yen for arbitrage.

Cross-Border Currency and Asset Interest Rate Arbitrage Model

International investment firms borrow large amounts of yen at about 1% interest rate from the Bank of Japan or directly in the Japanese bond market, then channel these funds into high-yield environments like the US, Europe, investing in stocks, bonds, or real estate. Because borrowing costs in yen are extremely low, even small future exchange rate losses can be offset by gains elsewhere, making the overall investment profitable. This approach is relatively low-risk for large institutions.

Warren Buffett’s Japanese Dividend Spread Trade

Post-2020, amid global quantitative easing, Buffett believed US stock valuations were too high and shifted focus to Japan. Through Berkshire Hathaway, he issued bonds to borrow low-interest yen and bought large-cap Japanese stocks. Subsequently, he pressured listed companies to increase dividends, buy back shares, improve liquidity, and eliminate cross-shareholdings. This strategy generated over 50% returns for Berkshire within two years.

The brilliance of this approach lies in completely avoiding exchange rate risk—borrowing yen to invest in Japanese equities, earning from dividend and bond yield spreads rather than currency fluctuations. For institutional investors with influence over corporate decisions, this operation involves far less risk than generally perceived.

The Fundamental Difference Between Carry Trade and Arbitrage

They are often confused, but the distinction is crucial:

Arbitrage refers to “risk-free profit,” exploiting price differences of the same asset across different exchanges or markets through timing, information, or regional disparities. Essentially, arbitrageurs eliminate market inefficiencies.

Carry trade involves holding assets with interest rate differentials, with traders actively accepting risks related to exchange rates, interest rates, and liquidity. Risk and reward are inherent features of this strategy.

Key Strategies for Successful Carry Trade

To achieve consistent profits in carry trading, one must master:

Precise timing: Investors need to determine their holding period in advance to select suitable targets for that cycle. A 3-month carry trade differs significantly from a 3-year one.

Historical trend analysis: Studying past relative price movements of investment targets can reveal patterns and trading opportunities. For example, USD/TWD exchange rate trends can serve as reference benchmarks.

Monitoring interest rate and exchange rate relationships: Staying informed about central bank policies, interest rate futures, and exchange rate expectations allows timely adjustments before market shifts.

The essence of carry trading is a careful balance of risk and reward—choosing the right timing, selecting appropriate assets, controlling leverage, and implementing proper hedging to maximize the strategy’s advantages.