25. Plummeting Yen Carry-Trade. The Japanese yen, long the home of the global carry-trade as the lowest interest cost source of funds of any major industrial market, began strengthening in August 2007. The yen had remained relatively quiet and above 118/$ for several months. Most analysts and arbitragers believed it would stay at 118, maybe falling to 120. As the U.S. sub-prime mortgage crisis hit in August 2007, U.S. dollar interest rates starting rising, initially adding some momentum to the carry-trade. But then on August 14, the rising concerns over the financial health of the U.S. economy caused a fall in the dollar, and the yen starting appreciating signif- icantly against the dollar (rising quickly to 114/$). This was devastating for the carry-trade, as a rising yen undermined the uncovered interest arbitrage benefits. Within days, things worsened. In an effort to increase the liquidity of the U.S. financial sector fearing rising mortgage-backed securities defaults, the U.S. Federal Reserve lowered the discount rate, which caused a fall in short-term interest rates. Using the following inputs and the exchange rate graphic, using a $1,000,000 notional principal (or Japanese yen equivalent), show how the Japanese yen carry-trade results in a negative invest- ment return after the rise of the yen and the fall of U.S. dollar interest rates:

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Arbitrage funds available ($) Spot exchange rate (V/S) $1,000,000 118.00 Three-month forward rate (/$) 117.33 Expected spot rate in go days (X/S) 118.00 U.S. dollar three-month interest rate 4.800% New US dollar three-month interest rate (Aug 15) 4:400% Japanese yen three-month interest rate 2.500% Daily Exchange Rates: Japanese Yen per U.S. Dollar 120 119 118 117 116 315 114 113 1 5 10 15 20 25 30 August Source: Pacific Exchange Rate Service