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

110

50

Jan -00

Ju l-0

0 Ju

l-0 1

Jan -01

Ju l-0

2 Jan

-02 Ju

l-0 3

Jan -03

Ju l-0

4 Jan

-04 Ju

l-0 5

Jan -05

Ju l-0

6 Jan

-06 Ju

l-0 7

Jan -07

Ju l-0

8 Jan

-08 Ju

l-0 9

Jan -09

Ju l-1

0 Jan

-10 Ju

l-1 1

Jan -11

Ju l-1

2 Jan

-12 Ju

l-1 3

Jan -13

Japanese yen per Australian dollar (monthly)

60

70

80

90

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.

Consider the strategy outlined in Exhibit C—a Euro- Indian rupee carry trade. An investor borrows EUR20 million at an incredibly low rate (again, because of ECB strategy to stimulate the sluggish European economy), say 1.00% per annum or 0.50% for 180 days. The EUR20 mil- lion are then exchanged for Indian rupees (INR), the cur- rent spot rate at the start of 2012 being a dramatic low of INR67.4 = EUR1.00. The resulting INR1,348,000,000 are put into an interest-bearing deposit with any of a number of Indian banks attempting to attract capital. The rate of interest offered, 2.50% (1.25% for 180 days), is not particu- larly high, but is greater than that available in the dollar, euro, or even yen markets. The account value at the end of 180 days, INR1,364,850,000, is then returned to euros at the spot rate of INR68.00 = EUR1.00, but at a loss. Although

The two periods of Aussie dollar appreciation are clear—after-the-fact. During those periods, an investor who was short yen and long Aussie dollars (and enjoying relatively higher Aussie dollar interest) could and did enjoy substantial returns.

But what about shorter holding periods, say a year, in which the speculator does not have a crystal ball over the long-term trend of the spot rate—but only a guess? Consider the one-year speculation detailed in Exhibit B. An investor looking at the exchange rate in January 2009 (Exhibit A) would see a yen that had reached a recent historical “low”—a strong position against the Aussie dol- lar. Betting that the yen would likely bounce, weakening once again against the Aussie dollar, she could borrow JPY50 million at 1.00% interest per annum for one year. She could then exchange the JPY50 million yen for Aus- tralian dollars at JPY60.91 = AUD1.00, and then deposit the AUD820,883 proceeds for one year at the Australian interest rate of 4.50% per annum. The investor could even have rationalized that even if the exchange rate did not change, she would earn a 3.50% per annum interest differential.

As it turned out, the spot exchange rate one year later, in January 2010, saw a much weaker Japanese yen against the Aussie dollar, JPY83.19 = AUD1.00. The one-year Aussie-Yen carry trade position would then have earned a very healthy profit of JPY20,862,296.83 on a one-year investment of JPY50,000,000, a 41.7% rate of return.

Investor borrows JPY50,000,000

at 1.00% interest

JPY50,500,000.00 71,362,296.83

JPY20,862,296.83

Converts yen to Australian dollars at

JPY60.91 = AUD1.00 JPY83.19 = AUD1.00

AUD820,883 AUD827,853 4.50% per annum

or 1.045

1.00% per annum or 1.01

Start End

The Australian dollars are then invested at the higher Australian dollar interest rate of 4.50% per annum for one year. The result, principal, and interest of AUD 827,853, is then converted back to Japanese yen at the current spot rate. With luck, talent, or both, the result is profitable.

The funds borrowed at 1.00% per annum bill need to be repaid in one year, principal and interest of JPY50,500,000.

360 days

exhibit b the aussie-Yen Carry trade

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5. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is constructed.

6. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange rate index into a real effective exchange rate index?

7. Exchange Rate Pass-Through. What is exchange rate pass-through?

8. Partial Exchange Rate Pass-Through. What is partial exchange rate pass-through, and how can it occur in efficient global markets?

9. Price Elasticity of Demand. How is the price elasticity of demand relevant to exchange rate pass-through?

10. The Fisher Effect. Define the Fisher effect. To what extent do empirical tests confirm that the Fisher effect exists in practice?

QUeStIONS These questions are available in MyFinanceLab.

1. Law of One Price. Define the law of one price care- fully, noting its fundamental assumptions. Why are these assumptions so difficult to apply in the real world in order to apply the theory?

2. Purchasing Power Parity. Define the two forms of pur- chasing power parity, absolute and relative.

3. Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements for a law of one price measurement of purchasing power parity?

4. Undervaluation and Purchasing Power Parity. Accord- ing to the theory of purchasing power parity, what should happen to a currency that is undervalued?

170 CHAPTER 6 International Parity Conditions

Mini-Case Questions 1. Why are interest rates so low in the traditional core

markets of USD and EUR? 2. What makes this “emerging market carry trade” so

different from traditional forms of uncovered interest arbitrage?

3. Why are many investors shorting the dollar and the euro?

the rupee had not moved much, it had moved enough to eliminate the arbitrage profits.

Carry trade activity is often described in the global press as if it is easy or riskless profit. It is not. As in the case of the euro-rupee just described, the combination of inter- est rates and exchange rates is subject to a volatile global marketplace, which does indeed have a lot of moving parts. An accurate crystal ball will always prove very useful.

Investor borrows EUR20,000,000 at 1.00% interest

EUR20,100,000 EUR20,071,324

(EUR28,676)

Converts euros to Indian rupiah at

INR67.40 = EUR1.00

Convert INR back to EUR at spot rate of

INR68.00 = EUR1.00

INR1,348,000,000 INR1,364,850,000 2.50% per annum or 1.0125 for 180 days

1.00% per annum or 1.005 for 180 days

Start End

The Indian rupees are invested at 2.50% per annum, 1.25% for 180 days. The result, principal and interest of INR1,364,850,000, is converted back to euros at the spot rate in the market in 180 days of INR68.00 = EUR1.00. Unfortunately, the small movement in the spot rate has eliminated the interest arbitrage profits.

The funds borrowed at 1.00% per annum bill need to be repaid in 180 days, principal and interest of EUR20,100,000.

180-day period

exhibit c the euro-rupee Carry trade

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