One of your colleagues at Deutsche Bank thinks that the dollar is severely undervalued relative to the yen. He has calculated that the PPP exchange rate is ¥140/$, whereas the current exchange rate is ¥105/$

Question

Because interest rates are 3% p.a. lower in Japan than in the United States, he thinks that this is a good time to speculate by borrowing yen and lending dollars. What do you think?

Answer 1

Deviations from PPP are a weak reason to engage in speculation. While the data in the problem indicate that the dollar is 33.33% undervalued, because that is the amount of dollar appreciation that would be required to take the actual exchange rate from ¥105/$ to the PPP prediction of ¥140/$, we know that the return to PPP will not be an overnight event.

The empirical analysis of the issue indicates that the half-life of PPP deviations is around 5 years. Thus, you might expect that the dollar will appreciate by 16.67% over the next 5 years. But, uncovered interest rate parity actually suggests that the yen will appreciate in the short run, because the yen interest rate is 3% less than the dollar interest rate. Notice, though, that the correction back toward PPP can take place with differential rates of inflation in the two countries. If Japanese rate of inflation falls below the U.S. rate of inflation, the PPP prediction will begin falling toward the actual exchange rate. Finally, although the dollar is 33.33% undervalued, there is no guarantee that the undervaluation will begin to be corrected now. It may, in fact, get worse. If the undervaluation of the dollar goes to 50% over the next 2 years, you would lose 16.67% in the foreign exchange market which would not be compensated by the approximate 6% that you would earn by borrowing yen and lending dollars. Finally, do not forget that your boss in proprietary trading at Deutsche Bank would not be happy with such a situation.