For most of 2022, the Bank of Japan was maintaining yield curve control (YCC) by targeting a band of +/- 0.25% around zero for the yields of Japanese Government Bonds (JGBs) up 10-years (long-term interest rates). In December 2022, the Bank of Japan unexpectedly changed the band to +/- 0.50%, causing long-term interest rates to rise.

(a) Please explain the relationship between interest rates and the exchange rate of the Japanese yen against the US dollar, referring to relevant theories.

(b) How do you expect the Japanese yen to react to the widening of the yield curve control band in December 2022?

(c) Assume that an investor based in Japan holds US equities and bonds denominated in US dollars, but has payment obligations in Japanese yen. How is the investor exposed to currency risk? 

How can the investor described hedge themselves against adverse movements in the exchange rate? 

Answer rating: 100% (QA)

Solution a There is an inverse relationship between interest rates and exchange rates which is known as the interest rate parity theory According to t... View the full answer