Study Session 9

Recent news events helped reinforce some of the learnings from the SS on International Finance. A recent corrective drop in the Shanghai and Chezhen markets resulted in a lot of revisionist research on carry-trade. Carry-trade is the leveraging of lower foreign fixed interest rates. In real terms the Japanese Yen has a very low interest rate, which the government supports keeping low, the overall effect of which is to stimulate the Japanese economy and increase liquidity. But the same low interest rates encourage non-Japanese investors to borrow the Yen to leverage elsewhere, knowing that they won't have to pay a lot for the Yen. (This too should help the Yen because it appreciate domestically). In any case, the leverage is good unless the government unexpectedly raises interest rates (which it did, albeit a few months ago) and investors suddenly decide to reduce or repay those borrowings (which is part of the explanation for the correction - albeit in a different market). In any case, the principle behind all this, a relatively straightforward concept, but easily overlooked, is covered interest parity. And it is covered in our beloved textbook. Incidentally, if you go out and try to simulate or look for arbitrage opportunities using real life interest rates and forward/ spot rates, you might find that the numbers come out weird (as was my case). Then you might realize that you had totally forgotten the simple concept of direct vs. indirect quotes, and how it is not as intuitive as using DC/FC, although it is that simple.
Just some figures for laughs a/o March 2, 2007:
US interest rate: 5.25%
Japanese interest rate: 0.5%
Forward rate (DC/ FC, but meaning how many yen do i get for 1 USD dollar): 0.008889
Spot rate (DC/ FC): 0.008506

1+r d = forward(dc/fc)
1+r f spot (dc/fc)

generally, d> f, forward> spot