Aug. 10 (Bloomberg) -- The yen may extend gains against the euro and dollar on concern the U.S. subprime mortgage crisis is spreading through credit markets, prompting investors to trim riskier assets funded by loans in Japan.

Japan's currency yesterday rose the most since May 2001 versus the euro as the so-called carry trade unwound after BNP Paribas SA, France's biggest bank, froze three investment funds that owned subprime loans. U.S. and European stocks tumbled and Treasuries rallied yesterday as investors shunned risks and sought safety in government debt amid a credit crunch.

``The subprime issue continues to haunt the markets,'' said Steve Butler, director of currency trading at Scotia Capital Inc. in Toronto. ``Traders are extremely nervous. As long as the market continues to need to reduce risk, the yen should benefit.''

The yen traded at 161.63 per euro and 118.16 per dollar at 6 a.m. in Tokyo. The Japanese currency gained 2.2 percent against the euro and 1.3 percent versus the dollar yesterday. The euro bought $1.3679 after declining 0.9 percent yesterday.

The Japanese currency has gained 0.6 percent this week against the euro. The yen has advanced against all 16 major currencies tracked by Bloomberg since the beginning of July as investors exited the carry trade and subprime losses led to tightening lending conditions and a global rout of stocks, corporate bonds and emerging-market assets.

`Panicking Mode'

``It's panicking mode,'' said Christian Dupont, a senior currency trader at Societe Generale SA in Montreal. ``The carry trades are going to take it on the chin. In markets like that, if you don't have the position, let the dust settle before you enter.''

The overnight rates banks charge each other to lend in dollars soared to the highest in six years yesterday within hours of the biggest French bank halting withdrawals from funds linked to U.S. subprime mortgages.

The European Central Bank, in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned 94.8 billion euros ($130 billion) yesterday to assuage a credit crunch.

The Federal Reserve added $24 billion yesterday in temporary funds to the banking system, the most since April, while the Bank of Canada said it will provide liquidity to support stability.

``The ECB's actions were a telltale sign of a crisis,'' said Matthew Kassel, director of proprietary trading at ING Financial Markets LLC in New York. ``It helped a lot, but it doesn't in any way solve the problems.''

Stocks Tumble

The Standard and Poor's 500 Index fell 3 percent yesterday and the Dow Jones Industrial Average declined 2.8 percent. National benchmarks tumbled in all 18 western European markets. U.S. Treasuries rose, pushing the two-year note's yield down the most since 2004.

``The yen is trading pretty much in lock step with the equity markets,'' said Jay Bryson, global economist with Wachovia Corp. in Charlotte, North Carolina. ``The markets are thinking that if European banks have issues with subprime debt, then maybe there are other guys having the same issues.''

Japan's yen may rise to 112 per dollar by year-end, Bryson said.

Volatility implied by one-month yen options against the dollar rose to 10.5 percent yesterday, from 9.2 percent a day earlier, above the 7.4 percent one-year average. The volatility touched 10.575 percent on Aug. 6, the highest since May 2006. Higher volatility may discourage carry trades as it suggests greater exchange-rate fluctuation risk.

Japan's benchmark borrowing costs of 0.5 percent are the lowest among major economies and compare with 5.25 percent in the U.S., 4 percent in the euro region, 6.5 percent in Australia, 8.25 percent in New Zealand and 5.75 percent in the U.K.

The carry trade has weakened the yen by 18.2 percent against the New Zealand dollar over the past 12 months, 13.1 percent versus the Brazilian real, 12.1 percent against the Australian dollar and 8.2 percent against the pound.

To contact the reporter on this story: Min Zeng in New York at mzeng2@bloomberg.net.

Last Updated: August 9, 2007 17:04 EDT