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By Rachel Breitman
NEW YORK, Aug 9 (Reuters) - The yen rose sharply on Thursday as investors ran from risky low-interest rate-funded trades following further revelations the U.S. subprime mortgage crisis has spread to Europe.
The euro fell as much as 2 percent against the yen and 1 percent against the dollar after France's largest listed bank, BNP Paribas (BNPP.PA: Quote, Profile, Research), temporarily suspended redemptions at three funds worth 1.6 billion euros ($2.2 billion), sending overnight U.S. and euro zone borrowing rates soaring.
The high-yielding Australian and New Zealand dollars dropped by more than 2 percent against the yen, as investors scrambled to unwind carry trades. In carry trades, investors borrow in low-yield currencies like the yen to finance investments denominated in high-yield currencies.
"It's a flight from risk," said Richard Franulovich, senior currency strategist at Westpac Bank in New York. "Those currencies with high yields that have been backed by speculative inflow have been crushed."
Reflecting liquidity fears, European overnight borrowing rates spiked to their highest level since October 2001, prompting the European Central Bank to inject around 95 billion euros ($130 billion) into the system in a quick overnight tender.
In late afternoon New York trading, the dollar was down 1.21 percent against the yen at 118.18 yen <JPY=>, while the euro slid 2.08 percent to 161.64 yen <EURJPY=>, the biggest daily rise in two years.
U.S. equities markets sputtered, with the Dow Jones industrial average (.DJI: Quote, Profile, Research) down by 2.83 percent, as investors turned to safe-haven U.S. Treasury bonds.
In recent weeks, the yen has maintained a tight negative correlation with U.S. stocks, with investors buying back yen when stock prices fall.
Implied volatility on one-week euro/yen options <EURJPYSWO=>, a gauge of the magnitude of swings expected in the spot market, jumped briefly to the highest since April 2004, according to Reuters data.
The euro slipped 0.88 percent to $1.3673 <EUR=>, well below July's record high near $1.3850.
Meanwhile, high-yielding currencies fell, contrasting with Wednesday's trend, when investors embraced carry trades after the Federal Reserve predicted sustained economic growth.
Underscoring the extent of the problems in the credit market, the costs to insure the debt of Bear Stearns Cos. (BSC.N: Quote, Profile, Research) and mortgage lender Countrywide Financial Corp. (CFC.N: Quote, Profile, Research) rose on Thursday.
Benchmark credit derivative indexes, known as the CDX series, were also wider. The investment-grade credit derivative index was around 6 basis points wider while the High Volatility index, which includes mainly "BBB"-rated credits, was also roughly 6 basis points higher.
Analysts at CitiFX said the euro may continue to be vulnerable against the dollar and the yen if credit market sentiment does not improve.
"With significant breathing room ahead of initial technical support in the $1.3609 (per euro) region, it is not clear that today's move is stretched, arguing against standing in the way of further euro/dollar sell-off," said CitiFX strategists in a research note.
(Additional reporting by Gertrude Chavez-Dreyfuss and David McMahon)