Forex Interest Rates. Currency Arbitration. The impossible is possible.
After the United States abandoned the “gold standard” in 1973, when all currencies were pegged to the dollar, and it, in turn, was pegged to gold, the value of foreign currencies began to be determined on market conditions according to the law of supply and demand, and also obeying fundamental laws. among which three can be distinguished:
- Interest rate parity law;
- Law on the value of commodity prices;
- Act on inflation expectations.
Each of these laws acts on the foreign exchange rate simultaneously, but unevenly, and depending on market conditions, however, the “Interest Rate Parity Law” is the first and the main one that has the greatest impact on exchange rates.
Money has a positive temporary advantage. In other words, any economic entity with money prefers to spend it here and now. It is on this property of money that the fee that the borrower pays the lender is based. At the same time, money is the universal equivalent of value, and a measure of the value of money is borrowed interest. In pursuing a monetary policy, the central bank sets the minimum cost of money (percentage) for commercial entities, usually the cost of borrowing for a short-term period, for example, for one day or two weeks. However, as we already know, at Forex the value of any currency is determined relative to the US dollar, which is why the Fed’s key rate plays a major role in the market.
Speaking of currency quotes, we mean a currency pair, which consists of two currencies. Usually it is the US dollar and some currency, for example: – EUR / USD, GBP / USD, AUD / USD or USD / JPY, USD / CAD, USD / CNY. Relationships are less common: – EUR / JPY, GBP / JPY, EUR / GBP, AUD / JPY, etc., called cross rates, but they are special cases for which the same principles apply as for currency pairs formed with the US dollar, with the exception that in reality, the volume of transactions in the cross rate may be small, and the quotation of these pairs is converted by the central bank through the dollar and is artificial.
If currency quotes are expressed in the names of central banks, it will look like this: – European Central Bank / Federal Reserve System, Bank of England / Federal Reserve System, Reserve Bank of Australia / Federal Reserve System or Federal Reserve System / Bank of Japan, Federal Reserve System / Bank of Canada, Federal Reserve / People’s Bank of China. In general, the higher the interest rate set by the central bank, the more expensive the currency issued by this central bank, the greater the difference between interest rates, the higher or lower the exchange rate.
Japanese Yen Arbitration
The traditional currency in which international investors receive financing is the Japanese yen. Faced with a recession in the mid-90s, the Bank of Japan was forced to lower its key rate to the lowest levels, which allowed investors and speculators to receive financing in yen at a low-interest rate and to distill it to other markets, primarily to the US market. This caused a very interesting effect that traders around the world use.
The fact is that, while receiving financing in yen, during the growth of the stock market, investors and speculators receive loans for a short period to reduce costs in the form of increased interest, usually, this is a period of one to six months. When the stock market grows and assets rise in price, investors can easily extend the financing for the next period of time. The massive sale of the yen against the US dollar and other currencies causes its decline and the growth of the USDJPY pair. However, when the stock market falls, investors are forced to close their positions in foreign currencies and buy a yen to cover the financing received. Therefore, when the stock markets fall, the Japanese yen rises in price, and the USDJPY pair falls.
Due to the fact that most of the financial transactions are carried out in US dollars, with the stock markets falling, the dollar is also rising against most currencies except the Japanese yen.
Using the method of the dependence of the Japanese yen on the behavior of stock markets, traders should take into account that if the stock market grows, the yen can both increase and decrease. However, in the case of declining markets, the yen will increase with a probability of 95%.