Although the spread between the yen and the other four currencies is large at the moment, implying a profitable spread buying yen calls and selling one of the lower curves — a continuation of the spread differential is not guaranteed. The yen’s volatility is largely the result of Japan’s government lowering the value of the yen with respect to the dollar, as well as reducing the short-term interest rate to less than 1%. These monetary and currency-valuation policies have drawn criticism from countries connected to the euro, which does not have an equal chance at central bank intervention.
There is little doubt that the low Japanese interest rates and declining value of the yen have assisted traders who are interested in covered interest rate arbitrage or carry trades involving the yen and other currencies or securities.
Arbitrage implies that the differential between the spot prices of two currencies, expressed as an annual rate, should equal the difference between the two countries’ annual interest rates. In covered interest rate arbitrage, the currency that is undervalued is purchased with borrowed funds and then invested in securities of a second country. The principal and interest from the securities are sold one year forward and used to repay the original loan. A risk-free profit is available from the difference between the two annual rates.
Beyond transactions involving goods and services, the yen currently is valued relatively high in the futures and options markets for two reasons: 1) The currency value gains from the low interest rates resulting from central bank policy, and 2) volatility in the currency’s spot and futures prices drives up the market value of options.
Low interest rates set by the Japanese central bank may lead to carry trades — by borrowing the yen at a low rate and investing in another country’s risk-free bonds at a higher rate. For example, according to rates reported by Bloomberg on March 7, 2013, the government bond two-year yield is 0.05% in Japan and 2.88% in Australia. The two five-year yields are 0.11% and 3.10%. The rate spread is probably sufficient for profitable carry trades, assuming high leverage and after-hedging the risk of shifting exchange rates.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.