Mrs watanabe and the japanese yen carry trade mini case

167International Parity Conditions CHAPTER 6

SUMMarY pOINtS

■ Parity conditions have traditionally been used by econo- mists to help explain the long-run trend in an exchange rate.

■ Under conditions of freely floating rates, the expected rate of change in the spot exchange rate, differential rates of national inflation and interest, and the forward discount or premium are all directly proportional to each other and mutually determined. A change in one of these variables has a tendency to change all of them with a feedback on the variable that changes first.

■ If the identical product or service can be sold in two dif- ferent markets, and there are no restrictions on its sale or transportation costs of moving the product between markets, the product’s price should be the same in both markets. This is called the law of one price.

■ The absolute version of purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods.

■ The relative version of purchasing power parity states that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

■ The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensa- tion for expected inflation.

■ The international Fisher effect, “Fisher-open” as it is often termed, states that the spot exchange rate should change in an equal amount, but in the opposite direc- tion, to the difference in interest rates between two countries.

■ The theory of interest rate parity (IRP) states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or pre- mium for the foreign currency, except for transaction costs.

■ When the spot and forward exchange markets are not in equilibrium, as described by interest rate parity, the potential for “riskless” or arbitrage profit exists. This is called covered interest arbitrage (CIA).

■ Some forecasters believe that for the major floating currencies, foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.

At more than ¥ 1,500,000bn (some $16,800bn), these sav- ings are considered the world’s biggest pool of investable wealth. Most of it is stashed in ordinary Japanese bank accounts; a surprisingly large amount is kept at home in cash, in tansu savings, named for the traditional wooden cupboards in which people store their possessions. But from the early 2000s, the housewives—often referred to collectively as “Mrs. Watanabe,” a common Japanese surname—began to hunt for higher returns.

—“Shopping, Cooking, Cleaning Playing the Yen Carry Trade,” Financial Times, February 21, 2009.

Over the past 20 years, Japanese yen interest rates have remained extremely low by global standards. For years the monetary authorities at the Bank of Japan have worked

tirelessly fighting equity market collapses, deflationary pressures, liquidity traps, and economic recession, all by keeping yen-denominated interests rates hovering at around 1% per annum or lower. Combined with a sophisti- cated financial industry of size and depth, these low interest rates have spawned an international financial speculation termed the yen carry trade.

In the textbooks, this trading strategy is categorized more formally, as uncovered interest arbitrage (UIA). It is a fairly simple speculative position: borrow money where it is cheap and invest it in a different currency market with higher interest returns. The only real trick is to time the market correctly so that when the currency in the high- yield market is converted back to the original currency, the exchange rate has either stayed the same or moved in favor

Mrs. Watanabe and the Japanese Yen Carry trade1

Mini-case

1Copyright 2014 © Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

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168 CHAPTER 6 International Parity Conditions

in Japan. The Japanese banking sector, however, has been continuously in search of new and diverse investments with which to balance the often despondent domestic economy. It has therefore sought out foreign investors and foreign borrowers who are attractive customers. Multinational companies have found ready access to yen-denominated debt for years—debt, which is, once again, available at extremely low interest.

A third expeditor of the yen carry trade is the value of the Japanese yen itself. The yen has long been consid- ered the most international of Asian currencies, and is widely traded. It has, however, also been exceedingly vola- tile over time. But it is not volatility alone, as volatility itself could undermine interest arbitrage overnight. The key has been in the relatively long trends in value change of the yen against other major currencies like the U.S. dollar, or as in the following example, the Australian dollar.

the australian Dollar/Japanese Yen exchange rate Exhibit A illustrates the movement of the Japanese yen/ Australian dollar exchange rate over a 13-year period, from 2000 through 2013. This spot rate movement and long- running periodic trends have offered a number of extended periods in which interest arbitrage was highly profitable.

of the speculator. “In favor of” means that the high-yielding currency has strengthened against the borrowed currency. And as Shakespeare stated, “ay, there’s the rub.”

Yen availability But why the focus on Japan? Aren’t there other major cur- rency markets in which interest rates are periodically low? Japan and the Japanese yen turn out to have a number of uniquely attractive characteristics to investors and specula- tors pursuing carry trade activities.

First, Japan has consistently demonstrated one of the world’s highest savings rates for decades. This means that an enormous pool of funds has accumulated in the hands of private savers, savers who are traditionally very conserva- tive. Those funds, whether stuffed in the mattress or placed in savings accounts, earn little in return. (In fact, given the extremely low interest rates offered, there is little effective difference between the mattress and the bank.)

A second factor facilitating the yen carry trade is the sheer size and sophistication of the Japanese financial sec- tor. Not only is the Japanese economy one of the largest industrial economies in the world, it is one that has grown and developed with a strong international component. One only has to consider the size and global reach of Toyota or Sony to understand the established and developed infra- structure surrounding business and international finance

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Japanese yen per Australian dollar (monthly)

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100 The Japanese yen depreciated steadily against the Australian dollar from 2000 to late 2007

After a dramatic appreciation in 2008, the yen depreciated steadily again versus

the Australian dollar from 2009–2012

exhibit a the trending JpY and aUD Spot rate

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169International Parity Conditions CHAPTER 6

post 2009 Financial Crisis The global financial crisis of 2008–2009 has left a market- place in which the U.S. Federal Reserve and the European Central Bank have pursued easy money policies. Both cen- tral banks, in an effort to maintain high levels of liquidity and to support fragile commercial banking systems, have kept interest rates at near-zero levels. Now global investors who see opportunities for profit in an anemic global economy are using those same low-cost funds in the U.S. and Europe to fund uncovered interest arbitrage activities. But what is making this “emerging market carry trade” so unique is not the interest rates, but the fact that investors are shorting two of the world’s core currencies: the dollar and the euro.