Currency carry trade refers to the trade, where an investor borrows a currency from a country with a low interest rate, and then invests it in a country that yields a higher interest rate.
The Yen carry trade is the most popular example of the currency carry trade, because Japan has had low interest rates for a fairly long period now. Investors borrowed cheap Japanese Yen, and then bought securities like the US Treasury Bills, which gave them relatively higher interest rates. This type of thing worked really well when exchange rates were stable, and traders could leverage their investments to get great returns. But, the downside is that since two currencies are involved, fluctuations in exchange rates can kill all and any profits you make on your trade.
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Since fundamental factors impacting the economy do not change overnight, more often than not, the major crashes (excess of 10% in one day) occur due to technical factors.
One such technical factor that is causing the current crash is deleveraging. A lot of the current stress in the stock markets has been attributed to deleveraging.
A lot of financial investors use borrowed money to invest in stock markets and other asset classes. When the going is good, the investors make a lot of money and the cost of borrowed money is always less than the profits that they make due to rising prices.
However when stocks and other assets start to decline, then the investors either need to pump in more money to keep their portfolios stable or wind up their positions.
Such winding up of positions, where the investors sell of their stocks and repay their debt is called deleveraging. They are getting rid of their debt or leverage and to do that, they are selling stocks and other assets.
By selling stocks in such large quantities, they are depressing the stock prices, due to which other investors are forced to deleverage and a vicious cycle is set into motion.
About a few months back, another phrase had become quite popular – Yen Carry Trade. This was a situation where Japanese investors could borrow cheap money in Japan and invest it around the world.
The current strengthening of Yen shows that the Yen positions are getting wound up and Yen is finding its way back home and strengthening its currency. The Yen stands at about 90 to a dollar, which is the highest it saw since 1995.
The good news in all of this is that since deleveraging is more of a technical factor and not fundamental one, the markets are likely to recover sooner than in the case of a deep or prolonged recession.