Hedge funds gambling on highly leveraged bets in the markets driven by the gap between Japan’s low interest rates and higher ones elsewhere may have seen a year’s worth of potential profits wiped out in ten days as the yen has surged.

Investors in the yen “carry trade” have been badly wrong-footed by the leap in the value of the Japanese currency, which rose yesterday to an 11-week high of 117 to the dollar.

“Undoubtedly, there will have been significant pain suffered by a number of players,” Adam Chester, the chief economist in the treasury department of HBOS, said.

Billions of dollars may have been lost by hedge funds and traders who have failed to cap their exposure in any way – although precise estimates are impossible because of wide variations in estimates of the size of the trade.

Hiroshi Watanabe, the leading Japanese financial diplomat, estimated conservatively this week that the carry trade was worth between $80 billion (£41 billion) and $160 billion. On that basis the yen’s steep rally since February 23 would have left carry-trading speculators exposed to potential paper losses of $3.1 billion to $6.2 billion.

Some estimates of the trade go as high as $1 trillion, however, which would magnify these potential losses. Hedge funds and proprietary traders in the big investment banks routinely conduct carry trades, borrowing cheaply in Japan, converting to other currencies and investing the proceeds in higher-yielding securities. Until recently, the rush to conduct yen carry trades has helped to weaken further an already depressed yen, boosting profits in a virtuous circle for hedge funds.

However, analysts say that this virtuous circle is in danger of turning into a vicious one, with hedge funds rushing to unwind their positions, boosting a resurgent yen and triggering further unwinding.

“The risk is there will be a further scramble to unwind positions,” Mr Chester said. He gave warning that there was “some chance” of a bounce in the yen as large as that of the autumn of 1998, when it surged from Y148 to the dollar to Y111.8, triggering market turmoil and inflicting punishing losses on speculators.

One manager of a large London fund of hedge funds said: “With 8,500 to 9,000 hedge funds in existence, undoubtedly some will have been hurt.”

While more prudent hedge funds may have used complex trading strategies and financial instruments to insulate themselves against a sharp appreciation in the yen or an outbreak of market volatility, the less conservative were probably heavily exposed. The Japanese currency’s gains yesterday were fuelled as worries over US economic prospects hit the dollar after figures showed that American consumers’ confidence had dropped to its lowest in five months.

Amid a nervous climate among speculators who have staked billions on the carry trade, the impact of any negative news for the dollar is being amplified. As any such news pushes the dollar down, and adds to upward pressure on the yen, carry-trade speculators have greater grounds to worry that the rising yen will undermine the profitability of their bets in the markets and are encouraged to unwind these positions. Since that requires them to buy the yen, the currency comes under yet more upward pressure.

At its low yesterday of Y116.75, the dollar was down about 3.9 per cent against the yen over ten days and was on track for its biggest loss in about 14 months. The rise roughly equates to the differential between Japanese borrowing rates and yields in other jurisdictions, therefore having the potential to wipe out all gains. “We’re seeing a continuation of the carry trade unwinding,” Alan Ruskin, of RBS Greenwich Capital, said.

Attempts by officials to calm edgy markets did little to halt the appreciation of the yen. Mr Watanabe insisted that there were no signs that traders were rushing en masse to bail out of carry-trade positions.

“I don’t think there’s too much concern,” he said. “We don’t have any sign of herding or bandwagoning this week. I don’t think that’s a concern for me.”

Analysts said that the turbulence hitting carry trades could persist for some time. Ian Stannard, the currency strategist at BNP Paribas, said: “The carry trade is still very much under pressure and the yen is likely to continue to make gains. We are still in the situation where asset market volatility is causing some concerns with regards to the carry trade, and that’s leading to some upward pressure on the yen.”

Another fund-of-funds manager said: “The whole world was borrowing in yen. We were living in cheap currency. Those who use leveraging quite a lot will be well caught.”

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