Unwinding yen carry trade highlights need for tech-led risk mitigation

Key Takeaways

• Unwinding yen carry trade shows inherent risk of FX markets.
• Volatility reminds industry of the need for technological tools.
• Market participants must be able to mitigate and anticipate risks.

The sudden volatility of the yen in 2024, after years of stability, has underscored the inherent risks in foreign exchange (FX) exposure. It also highlights the need for traders to have effective risk management strategies, especially when the momentum in a currency switches direction, as with the unwinding yen carry trade.

What is a carry trade?

A carry trade, a common FX strategy, involves borrowing in a low-interest-rate country and investing in higher-yield assets or currencies in a country with higher rates. The profit, or “carry,” is the difference between the borrowing cost and the investment return.

When conditions change, like rising interest rates in a low-rate country or falling returns in a high-rate one, investors reverse their trades: They sell assets and repay borrowed funds to reduce exposure and avoid losses, a process known as unwinding a carry trade.

What’s behind the unwinding of the yen carry trade?

The yen emerged as one of the most significant carry trades globally, driven by the Bank of Japan’s (BOJ) interest rate policy, which kept the currency weak. An export-led but nonetheless stagnant economy and deflationary pressures kept rates in negative territory for a prolonged period.

Things started to turn in March when the BOJ decided to raise its overnight interest rate into positive territory (0-0.1%) for the first time in 17 years. This move represented a major departure from Japan’s long-standing ultra-dovish monetary policy and caused significant reactions in financial markets.

Momentum accelerated in early August when the BOJ raised its interest rates by 15 basis points, leading to a stronger yen and a sharp sell-off in global markets. Shortly after, a disappointing US monthly jobs report heightened expectations that the Federal Reserve would cut US interest rates. The combination of these events led to the unwinding of yen carry trade positions, causing market turmoil.

Since then, the yen has been weakening against the dollar and euro, but should the BOJ lift interest rates again, volatility and unwinding could return with renewed energy.

Let’s examine the range of risks traders face in FX markets and how they can manage them.

FX risks to consider

While exchange rates constitute the fundamental risks in FX, market participants, from FX trading desks to corporates, must be aware of other concepts. These include:

• Translation risk, or translation exposure, refers to the potential impact on a company’s financial statements due to changes in exchange rates, which arises when a company holds assets, liabilities, or equities in foreign currencies.
• Transaction risk, which is the possibility of negative impacts on a company’s cash flow due to changes in exchange rates between the initiation and settlement of a transaction.
• Jurisdiction risk, while less common, can disrupt business operations in less stable regions due to sudden changes in a country’s laws.
• Carry trades, in particular, bring additional risks and considerations into play, including interest rate risk.
• Leverage risk is another major factor, given the often, large amounts of leverage involved in carry trades.
• The political and economic stability of the borrowing and investment countries is also a crucial factor.

The unwinding of yen-funded carry trades can disrupt global markets by increasing currency volatility and tightening liquidity. To manage these effects, close monitoring of interest rate policies, geopolitical shifts, and economic trends is key.

Tech solutions to the rescue

To do this optimally and in real time in complex and volatile financial markets, market participants must replace inefficient, manual-based legacy systems with modern technology stacks where automation plays a central role.

Automation streamlines manual tasks and allows market participants to focus on higher-value activities such as financial analysis. Automated tools also handle hedging schedules and pull transaction data, offering real-time insights that enhance decision-making and minimize risks.

Integrated infrastructure and operations are equally important, since disparate workflows lead to data silos, increasing risks and reconciliation errors. Integration, from the front office through to the back, ensures consistent data flow and clear exposure visibility.

Likewise, artificial intelligence (AI) improves data processing, pattern recognition, and prediction of interest rate changes and market movements. However, poor data quality and regulatory uncertainties can hinder AI adoption.

Big data analytics and effective data analysis, along with AI, are vital tools for improving decision-making and efficiency. Big data analytics processes large datasets to identify long-term trends and predict macroeconomic shifts. Effective data analysis provides timely insights for daily operations, allowing traders to identify short-term trends and adjust strategies quickly. By combining the immediacy of effective data analysis with the foresight offered by big data analytics, traders can better mitigate risk.

Integrating and accessing all the above through application programming interfaces (APIs) and cloud computing would ensure a scalable, seamless and optimal route to accessing and managing data, and therefore risk, in real time.

The volatility of the yen in August highlights how quickly market conditions can change and underscores the need for effective risk management.

Investing in cutting-edge solutions is a big decision, but the increasingly complex nature of financial markets and rising geopolitical tensions mean it is one that will provide a return on your investment and keep you ahead of competitors.