SINGAPORE, Aug 7 (Reuters) - Global stock and bond

markets, in particular Japan's, are being rocked by an unwinding

of the hugely popular yen carry trade.

That trade, which involves borrowing yen at a low cost to

invest in other currencies and assets offering higher yields, is

being wrecked by Japan's rate increases, a volatile yen and

imminent rate cuts in the United States and other economies.

Here is a deeper look at the yen carry trade.

HOW DOES THE CARRY TRADE WORK?

It involves borrowing the yen, or any other currency

with similar super-low interest rates, then using it to buy

currencies with better yields.

The yen has been the funding currency of choice for carry

trades in U.S. dollars, Mexican pesos, New Zealand

dollars and some others.

The trade involves buying the higher-yielding currency with

the borrowed yen to invest in bonds or other money market

instruments in that currency.

At the end of a usually short-term trade, the investor

converts the dollars or pesos back into yen, and repays the

loan.

Annualised returns typically can be around 5% to 6% on

dollar-yen carry trades, which is the difference between U.S.

and Japanese rates, with a scope for more gains were the yen to

depreciate during that term.

WHAT IS THE GENESIS OF THE YEN CARRY TRADE?

If defined broadly as using a low-yielding yen to buy

higher-yielding foreign assets, then its origins can be traced

back to 1999 when Japan struck policy rates down to zero after

its asset price bubble burst.

The Japanese turned to international markets to get anything

better than the zero yields at home, ploughing trillions of

dollars into foreign markets and thus turning Japan into the

world's biggest creditor nation.

The carry trade as we know today, which involves yen

borrowing by largely international investors, kicked off in 2013

under Prime Minister Shinzo Abe's quantitative and qualitative

easing that coincided with rising rates in the United States and

a depreciating yen.

Those trades reached new, gargantuan proportions over the

course of 2022 and 2023 as the Federal Reserve raised rates

rapidly to rein in inflation even as the Bank of Japan (BOJ)

kept its short term rates negative, and as the yen swooned.

HOW LARGE IS THE YEN CARRY TRADE?

No one is quite sure. Using the narrowest definition of a

pure currency carry trade, analysts point to the $350 billion of

short-term external loans by Japanese banks as one estimate of

yen-funded trades in the world.

That number could be an exaggeration if some of those loans

are commercial transactions between banks or loans to foreign

businesses needing yen.

But it could be also understating the actual size of yen

carry trades because there could be billions of yen the Japanese

themselves have borrowed to invest in markets at home.

Actual positions could be amplified because of how hedge

funds and computer-driven funds use leverage.

Add to that the massive investments Japanese pension funds,

insurers and other investors have made abroad. Japan's foreign

portfolio investments were 666.86 trillion yen ($4.54 trillion)

at the end of March, Ministry of Finance data shows - more than

half in interest rate-sensitive debt assets, albeit most of it

long term.

WHY IS THE YEN CARRY TRADE UNRAVELLING?

To be sure, the BOJ has only started raising rates and its

overnight rate is just at 0.25% while dollar rates are roughly

5.5%.

But carry trades are more sensitive to currency moves and

rate expectations than the actual level of rates, analysts say.

The mere talk of further rate rises in Japan and Fed rate

cuts by September has driven the yen up 13% in a month and

narrowed the yield gap, completely wiping out the slim gains in

pure yen-dollar carry trades.

And as the big leveraged investors cut their billions of

loss-making yen carry positions, they are being forced to

de-leverage and shed other stock and bond holdings.

($1 = 146.8600 yen)