Examining the interest rate parity between U.S. and Japan

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Journal article

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The Journal of American Academy of Business

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Library of Congress, Washington


In this paper, the characteristics and the dynamics of the interest rate parity between the U.S. and Japan, as reflected by the Eurodollar and Euroyen futures markets, are examined. In an efficient market, the interest rate parity residual, as defined by the difference between the Eurodollar rate and the Euroyen rate plus its forward premium, have a theoretical value of zero. Using daily closing prices for the Eurodollar, Euroyen, and the Japanese yen futures, it is found that the interest rate parity do not hold in absolute term. Specifically, Japan has a higher rate than the U.S. even after adjusting for the currency return or forward premium. Such disparity is likely to be due to default risk differential. Furthermore, it is found that the disparity tends to converge to some normal or equilibrium level rather than moving in a random manner. This implies that even if the interest rate parity does not hold in absolute terms, it still might hold in relative terms over time. It can be inferred that the parity condition may not be true to covered interest arbitrage conditions as capital flow disruptions phenomenon occur as have been witnessed since the Great Recession. The pervasive quantitative easing, interest reductions and expansionary economic stimuli put into effect by Japan and USA to raise economic performance have relatively differing impact on the economic growth of the two economies. In general, it can be argued that the tenuous parity relationships of exchange rates’ determinations that are entertained during normal economic conditions have been tested since the Great Recession. The unfolding global economic environments, the divergent monetary policies of the Fed, ECB and Bank of Japan as well as Brexit are adding to possible distortion in exchange rate determinations. The enhanced volatility of exchange rates triggered by differing economic performances and relatively different economic tools used by different nations should make the determination of equilibrium exchange rates much more difficult. The study by A. Mulugetta, Y. Mulugetta and A. Tessema (2016 ) refuted the parity conditions and confirmed that the changes in exchange rates were more volatile during the Great recession in comparison to the pre- or post- recession periods for industrialized nations. It is also found that the exchange rates were more volatile for emerging nations. At a time of diverse economic performance among advanced nations, some important research questions need to be addressed as new economic challenge has begun to emerge. Mulugetta el al (2016) had raised several questions addressing the exchange markets disruptions. “Has the QE by industrialized nations and regions, such as the U.S.A., Japan, Switzerland, and Euro Zone, depreciated their currencies and brought the demise of the underpinning of the freely fluctuating exchange rate system? Has the reverse of stimulus expansion or quantitative easing and prelude of interest rate hike by the Fed triggered exchange control and some other forms of indirect interventions by other nations including emerging economies? Indeed, interest rates hike and imposition of exchange control have been implemented by several developed and emerging countries like Argentina, Brazil, India, Indonesia, Korea, South Africa and Turkey. How are the immensely increased balance sheets of central banks of countries, such as the U.S.A., Japan, Eurozone and Switzerland, that have used QE as a tool for economic expansion as well as to fight currency appreciation and/or to induce currency weakness, going to be maintained? Will the Fed expected interest rate increase give pause to many central banks that were using QE to nudge growth in their economy and lower the exchange rates of their currencies?” Would such scenarios usher more speculative carry trades in an era of nonexistent freely fluctuation exchange rates system? In the same vein, Joeng (2009) stated that the returns on Yen carry trade are consistently positive and the returns are not due to the lower interest rate in Japan when compared to other countries, but due to change in exchange rates. As the value of the Yen started to increase, speculators, such as hedge funds, have tried to unwind their positions repaying in Yen by borrowing U.S. dollars, which among other enhanced the liquidity crisis of early 2008. Similarly, Ahmed and Zlate (2013) have also found that interest differentials and global risk appetite to have been the main determinants of net private capital inflows. Classical studies by Froot and Thaler (1990) and Giovannini and Jorion (1987) had found exchange risk premium besides real interest rate difference as determinants of exchange rates movements. Engel (2016) stated”…A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity.” Contrary to such observation, in 2015, even though Japanese real interest rates were relatively lower than many other economies, including USA, there was a surge of speculative capital inflows to the Japanese capital markets. Hedge funders and exchange markets’ speculators were anticipating that the Yen will appreciate vis a vis other currencies even as the government of Japan continue with its QE and stimulus fiscal policies. In general, the enhanced volatility of exchange rates that are triggered by difference in economic performance and relatively different economic tools used by different nations will make the determinations of equilibrium exchange rates among currencies much more difficult. Moreover, given the managed direction of interest rates in Eurozone, Switzerland, Sweden, China and Japan among others in contrast to that of the expected direction of interest rate in U.S., the weakening or demise of cooperated and coordinated action may be looming. Thus, the December 2015’s action of the Fed to raise interest rate will usher divergent monetary policy that will impinge on relative value of currencies.

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Recommended Citation

Cheng, J., & Mulugetta, A. (2017). Examining the interest rate parity between U.S. and Japan. The Journal of American Academy of Business, 22(2), 63-67.

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