Epicenter or bystander? Currency connectedness around the 2024 yen carry unwind
This paper analyzes currency connectedness during the August 2024 yen carry unwind using Diebold–Yilmaz and multi-period Genizi R² measures, revealing that both GBP and JPY act as net receivers of spillover effects rather than the JPY being the sole epicenter, thereby suggesting investors should treat these currencies as a joint exposure when funding currencies fluctuate sharply.
Original paper licensed under CC BY 4.0 (https://creativecommons.org/licenses/by/4.0/). This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer
In the world of international finance, investors often treat different currencies like a basket of eggs, hoping that if one cracks, the others will hold firm. This strategy, known as diversification, relies on the idea that the value of a British pound, a Japanese yen, or a Swiss franc will not all move in the exact same direction at the exact same time. However, when markets become stressed, these eggs can sometimes crack together. A specific type of investment, called a carry trade, makes this risk particularly sharp. In this setup, investors borrow money in a currency with very low interest rates, such as the Japanese yen, and use it to buy assets in currencies with higher returns. As long as the cheap currency stays cheap, the strategy works. But if that cheap currency suddenly becomes more valuable, the investor faces a double blow: the loan they took out becomes more expensive to pay back, and they are forced to sell their other assets quickly to cover the loss. This sudden selling can cause a chain reaction, where the panic spreads from the original currency to others, making the entire portfolio move as one.
In August 2024, this exact scenario played out. The Bank of Japan raised its interest rates slightly, causing the yen to jump in value against the US dollar by nearly 7.5 percent in a single month. This event triggered a rapid unwinding of positions, where investors rushed to exit their trades. While the yen was the obvious center of the storm, the real question for investors was whether the panic was contained to the yen or if it had spread to other major currencies like the British pound, the euro, and the Swiss franc. Did the yen act as the epicenter of the crisis, dragging everything else down with it, or were other currencies merely bystanders caught in the crossfire? To answer this, researchers Hongquan Li and Zhenting Gong from Hunan Normal University looked at fifty years of monthly data, tracking how these four major currencies moved in relation to one another. They did not just look at how much each currency changed in price; instead, they measured how much the uncertainty of one currency's future value was explained by the movements of the others.
The researchers used two different mathematical approaches to map these relationships, treating the currencies as a connected system where a shock to one part ripples through the rest. One method looked at how much each currency contributed to the overall confusion in the market, while the other measured how much of a currency's movement was jointly explained by the others. Both methods agreed on the big picture: during times of stress, the connections between these currencies tighten significantly, meaning that diversification fails and the currencies move together. Over the entire fifty-year period, both methods identified the British pound and the Japanese yen as the currencies most affected by the rest of the group. They were the ones receiving the most influence from the others, rather than driving the movement themselves.
When the researchers zoomed in on the specific chaos of August 2024, the results offered a crucial correction to a common assumption. The yen had the largest price jump of the month, leading many to believe it was the sole focus of the market's attention and the primary source of risk. However, the analysis showed that the British pound was just as exposed as the yen. Both currencies were net receivers of connectedness, meaning they were both absorbing the shock from the rest of the portfolio. The two methods disagreed slightly on which of the two was more affected, but they were united in rejecting the idea that the yen was the only currency in trouble. The visible, dramatic rise in the yen's value did not mean that the risk was concentrated solely there; instead, the risk was shared, with the pound standing right alongside it as a vulnerable position.
This finding changes how investors should view their portfolios during a crisis. The study demonstrates that a large move in a funding currency does not automatically mean that currency is the only one at risk. The researchers found that while the total amount of connection between all currencies rose sharply during the unwind, the specific ranking of which currency was most vulnerable could shift depending on how the data was analyzed. Yet, the core conclusion remained steady: the British pound and the Japanese yen consistently sat at the bottom of the stability ladder, absorbing the most pressure from the system. The study suggests that when the funding currency moves sharply, investors should not look at that currency in isolation. Instead, they must consider the pound and the yen together, as both are likely to be the ones most deeply affected by the collective movement of the market. The data confirms that in a crisis, the largest price change is not always the best indicator of where the true risk lies.
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