Yen Carry Trade and the Subprime Crisis

Yen carry trades have traditionally been viewed in narrow terms purely as a foreign exchange transaction. We argue that the carry trade should instead be viewed in the broader context of global credit conditions. We show that the volume of Yen funding that is channeled for use outside Japan is mirrored by uctuations in the size of US broker-dealer balance sheets. Dierences in short-term interest rates across currencies help to explain the incidence of the carry trade, as does the measure of implied equity risk given by the VIX index. The conjunction of deteriorating credit conditions in the US and the weakness of the US Dollar against the Yen in the early stages of the credit crisis of 2007/8 can thus be seen as two sides of the same coin. Both can be seen as consequences of nancial sector deleveraging in the US. We are grateful to Tam Bayoumi, Bob Flood, Dick Herring and a referee for their suggestions, and to Tobias Adrian for encouragement and support. The views expressed in this paper are those of the authors and do not necessarily represent those of the Bank of Japan. 1