CASE 1
Mrs Watanabe refers to the Japanese housewives that seek to make full use of their house allowances. Even though generally investors are risk-averse, Mrs Watanabe unexpectedly played an important position in currency trading in order to fight with the zero-interest rate policy in Japan. Traditionally, Japanese were rather conservative in investments but due to the low interest rates, there started the carry trade. As it became so trendy to borrow Japanese yen to invest in carry trade, investors in that period would refer it to yen carry trade (Investopedia, 2017). Similarly, it happened to the West in this case which will be further explained in the following questions.
Question 1
Low interest rate system was implemented by the Federal Reserve System (Fed) because recession had taken place in the United States (U.S). But what has interest rate to do with recession? As interest rates increases, it limits the liquidity which is the amount of money available to invest. The biggest cause was the Fed, which often raised interest rates to safeguard the value of the dollar. Consequently, the reduced amount of resources available to invest had also decreased the confidence in investors to invest which lead to high unemployment rate in the US (Amadeo, 2017). Figure 1.1 shows that the unemployment rate was increasing since 2007.
Year
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
2007
4.6
4.5
4.4
4.5
4.4
4.6
4.7
4.6
4.7
4.7
4.7
5.0
2008
5.0
4.9
5.1
5.0
5.4
5.6
5.8
6.1
6.1
6.5
6.8
7.3
2009
7.8
8.3
8.7
9.0
9.4
9.5
9.5
9.6
9.8
10.0
9.9
9.9
(Source: Bureau of Labor Statistics)
Figure 1.1: United States historical unemployment rate
As a result from these two factors, the U.S economy was slowing down and the Fed had to take some alternatives to prevent the situation from deteriorating. Since the high interest rate was the cause, the Fed started to lower the interest rates, shown in the graph below:
(Source: TradingEconomics.com | Federal Reserve)
Figure 1.2: Unites States historical interest rate
Through the decreased interest rates, the liquidity risk will be lowered then the capacity to lend would escalate. The reason Fed wanted to increase the resources to lend was to stimulate the inactive economy. Therefore, the interest rates in USD were so low that it had been brought down to nearly 0%, between 0%-0.25% (refer to Figure 1.2) (Isidor, 2008). Suppressing interest rates can also trigger business spending on capital goods which will enhance the economy’s performance in the long run. Additionally, it encouraged home expenditures like purchasing houses. Home sales were generally higher when the mortgage rate was 5% than when it was 10% (Kliesen, 2011).
Likewise, the explosion of financial crisis also affected the Eurozone which consists of 19 countries. The impact of this crisis was so huge that it caused the European banks to suffer a loss of $1.3 trillion which was 35% higher than U.S total losses. Consequently, European banks were as aggressive as U.S in betting on debt and for former did not manage to do mend the mistakes as much as the latter. Resultantly, investors who were investing in Europe countries at that moment were extremely anxious about their investments (Thiel, 2010). Thus, the Eurozone implemented the similar solution as the United States: reduce the interest rate. In Figure 1.3, it can be clearly seen that the interest rate was brought down to 1% in the late 2009 and generally even lower for the next 7 years.
(Source: TradingEconomics | European Central Bank)
Figure 1.3: Eurozone historical interest rate
Thus, even if both U.S and Eurozone lowered their interest rates was to improve their economies, the side effects still lasted until today. It does not seem easy to increase the interest rates. What if they once again fall back to another crisis? Therefore, such decision must take every risk into account.
Question 2
Generally, uncovered interest arbitrage (UIA), also known as carry trade, is a form of transaction where arbitragers or investors borrow domestic currencies from a country that provides low interest rates. After that, they will switch these currencies into foreign currencies so that to enjoy a relatively high yield by depositing it in the foreign countries that exhibit high returns. (Eiteman, Stonehill, & Moffett, 2016). Benefits can be obtained via the difference in the interest yield between a country and the other. (Uncovered Interest Arbitrage, n.d.). After a period of time, investors will convert the currencies back to the home currencies and earn profit from it. However, the availability of profit depends on whether the domestic currencies exchange rate move favourably for the investors. If the domestic currencies depreciate or remain the same against the foreign currencies, there will be a profit. On the other hand, if it appreciates, inevitable lost will incur to the investors. In other words, UIA has foreign exchange risk. This also explains the term “uncovered” from the UIA as there is no cover for this risk from any forward agreement. (Staff, 2010).
From the case study (Eiteman, Stonehill, & Moffett, 2016), the “emerging market carry trade” of the world financial crisis in year 2008 to 2009 is a form of UIA. This is because due to the low interest rates in the U.S. and Europe, investors short EUR and USD and long currencies of emerging market for relatively greater interest rates. There are some contrasts between the emerging market carry trade and the traditional UIA.
Normally, Japanese Yen is used by investors for uncovered interest arbitrage due to the fact that they have long term, stable and low interest rates. This Japanese Yen is then invested in major currencies such as USD and EUR that offer greater yield. However, in this case, it can be seen that the major currencies, USD and EUR serve as the platform to obtain cheap credits instead. These currencies are switched into emerging economies’ currencies such as Indian Rupee and China Renminbi as emerging markets now exhibit relatively high interest rates. The situation has reversed.
Moreover, traditional UIA typically brings profit to arbitragers. It is shown that the traditional UIA of Japanese Yen carry trade brings about a profit after investors borrows and deposits Japanese Yen in Australian dollars. The emerging market carry trade on the other hand, that involve shorting the Euro for the Indian Rupee results in lost. The process of interest arbitrage is as shown in Figure 1.3 and Figure 1.4.
Figure 1.3: Japanese Yen carry trade
Figure 1.4: Emerging market carry trade
Based on Figure 1.3, the Japanese Yen (JPY) is converted into Australian Dollar (AUD) for higher interest rates. The spot exchange rates of JPY/AUD strengthened during the 1 year period as shown. This indicates that the JPY had depreciated in favour to the investors when the outcome turns out to be a very healthy profit of JPY 20,862,296.83. Whereas, for emerging market carry trade from Figure 1.4, the investors switch currencies from the Euro (EUR) to the Indian Rupee (INR) to deposit in India for higher return. However, during the next 180 days, the EUR unexpectedly appreciated against the INR. This small movement of the spot exchange rate eliminated the arbitrage profit that was supposed to result from the differential interest rates. Also, this situation has proven the theory that domestic currency strength of a country that exhibit low interest rate must remain or depreciate to boost the profit gained by the investors. Therefore, exchange rate risk serves as an important factor when investors look into investing currencies. The stability and prediction of the exchange rate movement are vital in many ways especially during times of financial crisis during which the emerging market carry trade appears.
Therefore, through UIA, the investors can obtain greater profit from the differential in interest rates as well as the appreciation of the foreign currencies.
Question 3
The global financial crisis during year 2008 to 2009 had affected countries like the United State and the Eurozone. Therefore, recession has fallen upon these countries. Due to that, their governments had implemented monetary policies that lowered interest rates in order to boost economic activities. Thus, it is now cheaper to borrow USD and EUR. However, this is just a part of the reasons that investors were doing so. The bankruptcy of the Lehman Brothers, a 158-year-old investment bank, followed by takeover of the stock-broking firm and investment bank Merrill Lynch had given the investors a picture that the US economic was worsening and would not recover so soon (Gokay, 2009). Hence, investors were expecting the values of dollars and euros to fall further in the foreseeable future. Consequently, through UIA, investors begin to short USD and EUR and convert them into currencies of emerging markets, such as Indian and China which has a relatively stable economic growth and offers greater interest rates. This will cause an increase in demand of the emerging markets’ currencies and hence these currencies will appreciate. The indirect effect was that the EUR and USD were weakened but it helped to increase the profit of the investors substantially.
Also, investors chose to short the USD and the EUR as an action to hedge against the risks that were resulted from the global financial crisis (Michael, 2010). This global incident has left an anemic economic in the US and the Europe zone. Therefore, instead of investing in local currencies, investors play the currencies by converting them to those that offer higher and profitable interest rates. Whether or not, profit obtained has depend on the skills and luck the investors have.
It can be seen that the investors have realized the best use of money during the financial crisis by shorting low yield currencies like the euro and the dollar. According to an article from Bloomberg Markets (Doff, 2017), the actions of borrowing low interest rate currencies and investing them for higher interest rate currencies may result in a reversal effect when there are too many people investing in this kind of trade. Therefore, it is wise to think about it before investing in interest arbitrage.
References
Amadeo, K. (2017). 11 causes of economic recession. The Balance. Retrieved from https://www.thebalance.com/causes-of-economic-recession-3306010
Bureau of Labor Statistics. (2017). Labor force statistic from the current population survey. Retrieved from https://data.bls.gov/timeseries/LNS14000000
Doff, N. (2017, May 30). History Says Emerging-Market Carry Trade Could End in Tears. Retrieved September 20, 2017, from Bloomberg Markets: https://www.bloomberg.com/news/articles/2017-05-30/history-says-emerging-market-carry-trade-can-only-end-in-tears
Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational Business Finance. Harlow: Pearson Education Limited.
Gokay, B. (2009). The 2008 world economic crisis: Global shifts and faultlines. Retrieved from https://www.globalresearch.ca/the-2008-world-economic-crisis-global-shifts-and-faultlines/12283
Insidor, C. (2008). Fed slashes key rate to near zero. CNN Money. Retrieved from http://money.cnn.com/2008/12/16/news/economy/fed_decision/index.htm?postversion=2008121617
Investopedia. (2017). Mrs watanabe. Retrieved from http://www.investopedia.com/terms/m/mrs-watanabe.asp
Investopedia. (2017). The credit crisis and the carry trade. Retrieved from http://www.investopedia.com/articles/forex/09/credit-crisis-carry-trade.asp
Kliesen, K. L. (2011). Low interest rates have benefits …and costs. Retrieved from https://www.stlouisfed.org/publications/inside-the-vault/spring-2011/low-interest-rates-have-benefits-and-costs
Michael, G. (2010, September 8). Top 5 Reasons To Invest In Currencies. Retrieved September 20, 2017, from Investopedia: http://www.investopedia.com/financial-edge/0910/top-5-reasons-to-invest-in-currencies.aspx
Staff, I. (2010, June 26). Uncovered Interest Arbitrage. Retrieved September 18, 2017, from Investopedia: http://www.investopedia.com/terms/u/uncovered-interest-arbitrage.asp
Thiel, S. (2010). European banks are worse off than wall street. Retrieved from http://www.newsweek.com/european-banks-are-worse-wall-street-74727
TradingEconomics. (2017). Euro area interest rate. Retrieved from https://tradingeconomics.com/euro-area/interest-rate
TradingEconomics. (2017). United Stated Fed funds rate. Retrieved from https://tradingeconomics.com/united-states/interest-rate
Uncovered Interest Arbitrage. (n.d.). Retrieved September 19, 2017, from INVESTORGUIDE.COM: http://www.investorguide.com/definition/uncovered-interest-arbitrage.html