Monday, March 19, 2007

Exchange Rates and Share Prices

Consider the following graphs:

The Japanese exchange rate and the value of the Nikkei 225 (the main share index in Japan) have been moving very closely together, especially this year.

There's also a very strong link between the exchange rate and the VIX index. I'm going to argue that these two are linked.

One of the main drivers of the exchange rate in Japan is what is called "carry trade". Interest rates are lower in Japan than in any other major economy. Therefore speculators can borrow in Yen and invest in higher yielding currencies overseas. When they do this, exchanging Yen into other currencies increases the supply of Yen, and so causes the value of the Yen to fall. And provided exchange rates don't change very much, the speculators can earn large profits from their investments, especially as they can be highly leveraged- using futures contracts on currencies, speculators can effectively borrow and lend many times the amount of money they have to invest.

It's difficult to estimate exactly how large the carry trade is, but it is potentially a very large portion of total currency flows with Japan, and therefore an important determinant of the exchange rate. Note, however, that carry traders can make large losses if the Japanese Yen appreciates significantly: they end up needing to repay their Yen debts at a higher price. Speculators wish to avoid this possibility by closing out their positions (that is, effectively repaying their Yen loans) whenever they believe that there is a high probability that the Yen will appreciate. But this is self-fulfilling: if enough speculators close out their positions at the same time, the Yen will appreciate as a result.

Any evidence of increased future volatility tends to make speculators nervous, and so they close out their positions. One excellent measure of expected future volatility is the Chicago Board of Exchange Volatility Index (VIX), which measures the amount of volatility predicted by futures contracts on the S&P 500. On February 26, this jumped by over 50%, causing speculators to close out their carry trade positions, and the Yen to appreciate by almost 2%. Since then, the two have moved in lock-step: when volatility in the VIX increases, speculators close out their positions, and the Yen appreciates. When volatility decreases, carry trade increases, and so the Yen depreciates. This pattern is likely to continue in the near future.

The link with share prices in Japan is because the real cost of investing in Japanese companies for outsiders moves in lock-step with the exchange rate. If the value of the Yen falls, Japanese companies are relatively cheap, so capital flows into Japan to purchase shares in Japanese companies. The effect of these inflows reduces the size of the depreciation caused by the carry traders, but is not enough to fully reverse it.

Another way to represent the data is in the following way: March 16 2006- March 16 2007, the correlation between the VIX and the Yen/USD exchange rate was 0.53, while the correlation between the Yen/USD and the Nikkei 225 was 0.52. Since February 1 this year, those correlations have jumped to 0.88 and 0.70 respectively. Based on the graphs above, this story can explain most of the behaviour in Japanese macro data in recent weeks.


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