Carry trade refers to the practice of speculators borrowing or selling lower-yielding currencies such as the yen or the Swiss franc at low costs and reinvesting in higher-return currencies and assets, such as the New Zealand dollar, the British pound and the South African rand.
"One of the things that carry trade relies on is relative low levels of volatility. Clearly the most recent catalyst has been the Chinese market meltdown triggering a meltdown in other emerging markets and basically a shift out of riskier assets into less risky assets."
The almost-free borrowing costs of the yen have also been responsible for financing massive bets in a variety of high-risk markets such as commodities and emerging markets. The carry trade is expected to be reversed as the Japanese economy strengthens and prices begin to rise.
"Over the past few years, the financial markets have become very speculative and highly leveraged. Today, we have seen the consequences of that aggressive risk appetite," said Kathy Lien, chief strategist at DailyFX.com. "Risk appetite is plunging as investors bail out of nearly all assets. Even gold has not escaped the liquidation."
Investors' risk appetite fell sharply in recent sessions on fears of the potential knock-on impact from subprime lending market woes and worries over Iran's nuclear plans. An almost 10% slump in Chinese shares overnight also encouraged traders to further unwind carry trade positions.
The massive build-up of carry trades over the past many years has led officials and economists to worry that a sharp reversal of these positions would have significant negative impact on financial markets.
