The Bombay Stock Exchange Sensitive Index or the Sensex as it is popularly known has fallen by around 350 points from Thursday's close, at the time of writing this. On Thursday (August 17, 2007) the stock market fell by 643 points. So in less than two days time, the stock market has fallen by 1000 odd points.

One of the reasons pointed out has been the meltdown in the subprime home loan markets in the United States. The other main reason for this fall has been the unwinding of the yen carry trade. In this piece lets try and understand how the "mild mannered" Japanese can impact the Sensex.

When Americans sneeze India catches cold

The Japanese economy over the years has not been growing at all. To encourage people to go out and spend money, and hence ensure that companies earn money and the economy grows, the Japanese central bank (there equivalent of the Reserve Bank of India [Get Quote]) has held interest rates at around zero per cent levels since March 2001.

So it makes immense sense for investors to borrow in the Japanese currency, yen, at almost zero per cent interest rates, and invest anywhere in the world.

Lets take a case of an investor who borrowed 12000000 yen in the middle of January 2007. Back then one US dollar got you around 120 yens. So the money was first converted into dollars. At 120 yens a dollar, the investor got $100,000 (12000000/120). This $100,000 was then invested in an emerging market like India.

But to invest in India, you need rupees. US dollars, won't do. Hence the $100,000 was then converted into rupees. At that point of time one US dollar was worth around Rs 44. Hence the $100,000 got the investor Rs 44,00,000 or Rs 44 lakh to be precise. This was invested in the Indian stock market. The Sensex on January 15 was at 14, 129.64.

Between January 15, 2007 and August 16, 2007 when the Sensex closed at 14,358.21, it has given a return of 1.62 per cent. Hence the Rs 44 lakh invested by the investor in India would have amounted to Rs 44.71 lakh as on August 16, 2007.

Now lets us say the investor decides to get out of the stock market on August 16, 2007. He sells out his investments for Rs 44.71 lakh and first converts the money to US dollars. Currently one US dollar is worth around Rs 41. Hence at this rate he gets  $ 109,053 (Rs 44 lakh/41).

He had taken the loan originally in the Japanese yen, and hence the US dollars need to be converted into yen. Currently one US dollar is worth 112 yen. At this rate $109,053, gives 12213947 yen. This means a profit of   213947 yen or 1.78 per cent on an investment of 12000000 yen for the investor.

This is the way yen carry trade happens. Now the million dollar question is "Why is this leading to the Indian stock markets falling?"

To understand this, we first need to understand why is the yen carry trade investor selling out of the Indian markets, or unwinding as the jargon goes.

The Japanese yen has been appreciating against the US dollar since late June, when it touched 124 yens to a dollar. Currently one US dollar is worth around 112 yens. With the yen appreciating the carry trade investor is getting lesser Japanese yen, for every US dollar. This is a losing proposition for him, since he needs to repay his loan in the Japanese yen.

If instead of 112 yens to a dollar, the carry trade investor got 124 yens to a dollar now, as he was in late June, he would have made a profit of 1522585 yen or 12.7 per cent on an investment of 12000000 yen.

So as we can see, the appreciation of the yen to 112 yens to a dollar, has led to the profit of the carry trade investor coming down drastically to 1.78 per cent.

The current feeling in the foreign exchange markets is that the yen will keep appreciating against the US dollar, due to various reasons. So if the yen were to appreciate to 110 yens to the US dollar, and the Sensex remained around the yesterdays level, the investor would make a loss of around 0.03 per cent. At 108, yens to a dollar, the loss would increase to 1.85 per cent.

Its obvious that no investor wants to make a loss. To avoid making a loss the yen carry trade investor is selling out at the current levels.