What is the Yen Carry Trade and How Do You Account for It?

Introduction to the Yen Carry Trade

The Yen Carry Trade is a financial strategy used by investors to borrow funds in a low-interest-rate currency, such as the Japanese yen, and then convert those funds into a higher-yielding currency to invest. The goal is to profit from the difference between the borrowing costs and the returns on investment. This strategy has been especially prevalent in Japan, where interest rates have been historically low for a long period, often close to zero or even negative.

For example, if a Japanese bank offers loans at a near-zero interest rate, an investor could borrow in yen, convert it to a stronger currency like the US dollar, and invest in US assets that yield higher interest rates. The profit arises from the “spread” between the low borrowing cost in yen and the higher returns on the investment.

But how do you account for it?

Step 1: Understanding the Financial Mechanism

To understand how to account for the yen carry trade, let’s break it down step-by-step:

1. Borrowing in Yen: The first step involves borrowing money in yen at a low interest rate.
2. Currency Conversion: Once the funds are borrowed, they are converted to another currency (e.g., US dollars).
3. Investment in a Higher-Yield Asset: The converted funds are invested in assets or securities that offer a higher return.
4. Interest and Currency Risk: While the investor earns returns on the investment, they also have to pay interest on the borrowed yen and face potential exchange rate risks.
5. Exit the Trade: Finally, when the investor closes out the trade, the assets are sold, the investment is liquidated, the foreign currency is converted back to yen, and the borrowed funds (principal + interest) are repaid.

Step 2: The Accounting Treatment

Now that we understand the basic structure of the yen carry trade, let’s look at how this would be reflected in the books of accounts. This example is tailored to an investor, such as a hedge fund, that engages in this type of strategy.

Step 2.1: Journal Entries

Let’s use an example to clarify the journal entries.

Example Scenario:

• Assume a hedge fund borrows ¥100 million at 0.5% annual interest.
• The fund converts this into USD when the exchange rate is 110 yen to 1 dollar, receiving approximately $909,091.
• The hedge fund invests this $909,091 into a US Treasury Bond that yields 3% annually.
• The fund holds the investment for one year, earns interest, and then closes the position.

Journal Entry 1: Borrowing the Yen

The first step is borrowing the yen. This involves recognizing a liability in the books.

Journal Entry:

The entry reflects that the fund now has a liability of ¥100 million to repay.

Journal Entry 2: Converting Yen to USD

The next step is to convert the borrowed yen into USD. In accounting, this would involve two things: (1) converting the currency and (2) recording the currency exchange rate.

Assuming the exchange rate is 110 yen per USD, the hedge fund receives approximately $909,091.

Journal Entry:

This entry reflects the currency conversion and the movement of cash between bank accounts.

Journal Entry 3: Investing in US Treasury Bonds

Next, the fund invests the $909,091 in a US Treasury Bond that yields 3%.

Journal Entry:

The entry records the purchase of the investment.

Journal Entry 4: Interest Earned from US Investment

At the end of the year, the hedge fund earns interest on its US Treasury Bond at a 3% annual yield, which amounts to $27,273 (3% of $909,091).

Journal Entry:

The interest revenue from the bond is recognized.

Journal Entry 5: Closing the Investment

After a year, the fund decides to sell the Treasury Bond and close the trade. Let’s assume the exchange rate between yen and dollars has moved to 105 yen to the dollar, meaning the dollar has strengthened relative to the yen. The fund liquidates the bond for its original value ($909,091) plus the interest ($27,273).

Journal Entry:

The entry records the sale of the Treasury Bond and the liquidation of the investment.

Journal Entry 6: Converting USD Back to Yen

Now, the fund converts the $936,364 back to yen at the new exchange rate of 105 yen per USD. The fund receives approximately ¥98,318,182.

Journal Entry:

This entry records the currency conversion back into yen.

Journal Entry 7: Repaying the Yen Loan

Finally, the fund repays the original ¥100 million loan plus interest (0.5% of ¥100 million, which is ¥500,000).

Journal Entry:

The loan is repaid in full along with the interest expense.

Step 3: Financial Statement Impact

To help visualize the effect of these transactions on financial statements, let’s go through the balance sheet and income statement.

3.1 Balance Sheet (Simplified)

After borrowing the yen, converting it into USD, and investing in Treasury Bonds, the hedge fund’s balance sheet would look like this:

Initial Balance Sheet After Conversion:

After Investing in US Treasury Bond:

After Liquidating Investment and Conversion Back to Yen:

3.2 Income Statement (Simplified)

The income statement would show the following:

Conclusion: Accounting for the Yen Carry Trade

The yen carry trade can be highly profitable, but it also carries significant risks, particularly related to currency fluctuations. By accurately accounting for the transactions involved, an investor can track the financial performance of this strategy.

Key takeaways for accounting:

• Loan Payable (Yen): The liability is recorded at the borrowed amount.
• Currency Conversion: Converting between currencies requires careful tracking of exchange rates.
• Investments and Revenues: Investments in foreign assets are recorded in the foreign currency, and interest revenue is recognized as earned.
• Risk Management: Exchange rate fluctuations can create gains or losses that must be recognized on financial statements.

Understanding the accounting for a yen carry trade gives investors and accountants insight into how to measure and manage the risks and rewards of this complex financial strategy.