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o 1he !apanese markeL ls LxporL drlven. 1he CovL.
keeps Lhe yen uSu raLe ln a narrow band Lo avold
unemploymenL and sumulaLe uomesuc Spendlng.
1he Worlds Second LargesL Lconomy has had a
negauve growLh raLe ln Lhe lasL Lhree years and ls
expecLed Lo grow aL 1.40 ° ln 2010/11
o 1he !apanese have amongsL Lhe lowesL lnLeresL raLes
ln Lhe world. Long Lerm CovL. debL ls already aL 180
° of CuÞ and expecLed Lo exceed 204 ° of CuÞ as
1he !apanese CovL Announced a uSu 1 1n 8udgeL for
2011 whlch wlll cause Þubllc uebL Lo rlse by uSu 483
8n Lo roughly $10.30 1n
o 1hus Lhe !apanese CovL. has a blased posluon Lo
keep lnLeresL raLes low- Lo fund lLs own debL, avold
deßauon and spur lnvesLmenL/domesuc demand.
o Cn a posluve slde 90 ° of Lhls debL ls held by
domesuc !apanese lnvesLors and !apan's Cumulauve
domesuc savlngs exceed $ 13 1n.
o 1he 8ank of !apan lnLervenes aggresslvely Lo keep
Lhe yen peak Lo proLecL lLs exporLers.
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• Powever Lhe !apanese populauon ls agelng. ln Lhe
nexL 20 years, 33 ° of lLs populauon wlll be over
63 years old. 1hls may cause a problem for fundlng
CovL. uebL ln Lhe fuLure.
- !apan has Lhe second largesL uSu reserves of
approxlmaLely uSu 1.03 1rllllon and en[oys a large
currenL accounL surplus. 8eLween 2001 and 2009
Lhese reserves Crew from uSu 330 8n Lo 1 1n.
- Powever durlng Lhls perlod Lhe !? remalned weak
vs.Lhe uSu and moved from 104 Lo 120 (lL
currenLly Lrades aL 91.30 aûer Lhe unwlndlng of
Lhe ?en C/f 1rade)
- 8eLween 2004-7 Clobal hedge funds explolLed Lhls
slLuauon 1hey undersLood fully well LhaL desplLe
low lnLeresL raLes Lhe exchange raLe wlll be
managed by Lhe CenLral bank of !apan and kepL
weak agalnsL Lhe uSu.
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- 1hls resulLed ln whaL ls popularly now
known as Lhe ?en Carry lorward 8aLe
- 1hls assumed many forms. lL resulLed ln
cross currency exposure (beLween Lhe !?
and Lhe relevanL counLer currency) and also
a cross asseL exposure
- L.g. a 8orrowlng of !? and subsequenL
lnvesLmenL ln a uS 1reasury 8lll creaLes a
uSu/!? Lxposure on maLurlLy of Lhe Loan/
lnvesLmenL.
- Pedge ArblLraged and 8orrowed ln !?. Sold
Lhe !? Lo converL lnLo uSu. 1hen lnvesLed
Lhe uSu ln CovL. bonds of new Zealand
whlch ylelded 8 °pa
- More commonly hedge funds borrowed
!? ,shorLed lL ln spoL markeLs Lo buy equlues
neera[ 8aLra CCMl CopyrlghL lnllnl1? 8uSlnLSS SCPCCL
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- Loglcally lf Lhe lnLeresL raLe on one
currency ls lower Lhan Lhe lnLeresL
raLe for anoLher currency (for a slmllar
maLurlLy) Lhen Lhe ñrsL currency musL
necessarlly Lrade aL a premlum (l.e. be
more expenslve ln Lhe forward
markeL) Lo Lhe second currency ln Lhe
lorelgn exchange markeLs such LhaL
Lhere ls no arblLrage posslble beLween
Lhe currency and money markeLs e.g.
lf lnLeresL raLes ln !? are aL 1 ° pa and
uSu are aL 3 ° pa for Cne year Lhen lL
follows LhaL Lhe one year forward !?/
uSu exchange raLe musL negaLe Lhls
2° ° lnLeresL dlñerence enurely.
neera[ 8aLra CCMl CopyrlghL lnllnl1? 8uSlnLSS SCPCCL
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Money Market Forex Market
JPY 6
Month
Rate
1.20% Spot Rate 85
USD 6
Month
Rate
3.60% 6 Month
rate
83.998 WHY
??
- LeLs LesL Lhls hypoLhesls
- A currency wlLh a low lnLeresL raLe
musL quoLe agalnsL a currency wlLh a
hlgher lnLeresL raLe aL such a premlum
ln Lhe forward forelgn exchange
markeLs such LhaL Lhe lnLeresL
dlñerenual ls negaLed
- unless Lhls happens arblLrage would be
consLanLly posslble (see example)
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- A Pedge lund borrows 6 monLh !? 83
Mn for 6 monLhs [ 1.20 ° pa
- Pe Lhen sells Lhls !Þ? ln Lhe SpoL lorelgn
Lxchange MarkeLs Lo geL uSu 1 Mn
- Pe lnvesLs Lhe uSu 1 Mn aL 3.60 ° pa ln
Lhe uS 1reasury 8lll markeLs
now aûer 6 MonLhs he owes Lhe
!apanese 8ank:
(83 Mn x 6/12 x .012 )+ (83 Mn)
!? 83,310,000
- Pls lnvesLmenL ln Lhe uS Lreasury wlll
yleld as follows:
1 Mn x 6/12 x .036 + 1mn=
uSu 1,018,000
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- 1hus unless Lhe 6 monLh luLures lx raLe ls
83.998 arblLrageurs would make rlsk free
reLurns l.e. Lhe yen musL quoLe aL a
premlum (more expenslve) Lo Lhe uSu Lo
Lhe exacL exLenL of Lhe lnLeresL raLe
dlñerenual or 83.998 ln Lhe 6 monLh fuLures
markeL.
- AnyLhlng weaker say 87 , Pedge lunds wlll
do Lhe followlng:
- lf !?/uSu quoLes 6 monLh fwd 87 Lhen Pls
would borrow !? aL 1.20 ° 87 mn (spoL
raLe), sell yen Lo geL uSu 1 mn
- lnvesL ln 3.60 ° 1 8llls and
- SlmulLaneously Lhe Pl Would buy !Þ? 6
monLh forward aL 87 for an equlvalenL uSu
of 1,018,000 (Why ?)
neera[ 8aLra CCMl CopyrlghL lnllnl1? 8uSlnLSS SCPCCL
!"# %#& '())* +,)-(). !)(.# - Aûer 6 monLhs Lhe Pl would owe Lhe
!apanese 8ank !Þ? 83,310,000
- lL would recelve uSu 1,018,000 from Lhe
uS markeL
- lL would have converLed Lhls uSu
AmounL already aL Lhe 6 monLh lwd
conLracL and would geL 88,366,000 !Þ?
(87 x 1,018,000)
- 1hus Lhe Pl would make rlsk free
3,036,000 Mn !Þ?
(88,366,000-83,310,000)
- 1hus Lhe lwd 6 monLh lx raLe of yen
musL quoLe exacLly aL 83.998 l.e. Lhe
premlum = lnL.raLe dlñerenual on Lhe
SpoL day.
- 1he real !?/uSu SpoL 8aLe aûer 6 monLhs
may however be hlgher or lower
neera[ 8aLra CCMl CopyrlghL lnllnl1? 8uSlnLSS SCPCCL
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- AnyLhlng sLronger say 83 , Pedge lunds wlll
do Lhe followlng:
• Pl wlll 8orrow uSu aL 3.60 ° 1mn (spoL
raLe), sell uSu Lo geL ?en 83 mn. 1hus he wlll
owe Lhe 8ank 1,018,000 aûer 6 monLhs
- lnvesL ln 1.20 ° !? ueposlL and
slmulLaneously buy uSu 6 monLh forward
worLh 83,310,000 !? (Why ?) aL 83 worLh
1,030,240
- 1hus he makes a proñL of 12,240 uSu per
uSu 1 Mn borrowed as an arblLrage proñL
wlLhouL assumlng any rlsk.
- 1hus only aL Lhe exacL exchange raLe of
83.998 does arblLrage geL prevenLed
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• Powever slnce Lhe !apanese CovL. wanLed Lo keep lLs
exporLs compeuuve lL dld noL llke Lhe ?en Lo appreclaLe
- 1hls resulLed ln Pl Laklng a beL on Lhe forward raLe of Lhe uSu/?en
malnLalnlng a narrow band such LhaL Lhe fund could Lake
advanLage of Lhe lnLeresL raLe dlñerenuals buL keep an open
forward posluon on Lhe exchange raLe ull maLurlLy and resulLed ln
1rllllons of uollars of ?en Carry lorward 1rade ull 2008.