Why are interest rates so low in the traditional core markets of USD and EUR?

Over the past 20 years Japanese yen interest rates have remaine Show more CaseJapanese yen interest rates 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. These low-interest rates have spawned an international financial speculation termed the yen carry trade. It is a relatively straightforward 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 for the speculator meaning the high-yielding currency has strengthened against the borrowed currency. However why the focus on Japan? First Japan has consistently demonstrated one of the worlds 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 conservative. 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 sector. Not only is the Japanese economy one of the largest industrial economies in the world but it is also 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 infrastructure surrounding business and international finance 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 yearsdebt 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 considered the most international of Asian currencies and is widely traded. It has however also been exceedingly volatile over time. However 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. 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 some extended periods in which interest arbitrage was highly profitable. Consider the strategy outlined in Exhibit C. An investor borrows EUR 20 million at an incredibly low rate say 1.00% per annum or 0.50% for 180 days. The EUR 20 million are then exchanged for Indian rupees (INR) the current spot rate being INR 60.4672 = EUR 1.00. The resulting INR 1209344000 are put into an interest-bearing deposit with any of some Indian banks attempting to attract capital. The rate of interest offered 2.50% is not particularly high but is greater than that available in the dollar euro or even yen markets. However the critical component of the strategy is not to earn the higher rupee interest (although that does help) it is the expectations of the investor regarding the direction of the INR per EUR exchange rate. 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 expecting the dollar and the euro to remain weak? Show less

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