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The Japan Premium

The USD/JPY is one of the major seven pairs of currencies that are most actively traded in the world. This pair is the most actively traded in Asia as well as the fourth most actively traded currency pair in the world. One advantage of this pair due to its heavy trade is that of low spreads as well as high liquidity and carry trade using Yen is one of the most common forms of carry trade. The rest of the seven pairs of most actively traded currencies consisted of the 4 majors:

EUR/USD (euro/dollar)

USD/JPY (U.S. dollar/Japanese yen)

GBP/USD (British pound/dollar)

USD/CHF (U.S. dollar/Swiss franc)

As well as the three commodity pairs which together with its variations made up about 95% of the Forex Trade. The three commodity pairs are:

AUD/USD (Australian dollar/U.S. dollar) – “aussie”

USD/CAD (U.S. dollar/Canadian dollar) – “loonie”

NZD/USD (New Zealand dollar/U.S. dollar) – “kiwi”

The author would like to advise all that Forex trade is more for the professionals and not a get rich quick and easy method. It is estimated that 95% of the players in the forex markets lost their money, which highlight the dangers of attempting to profit from such a market. Even for the major banks, they use a typical “scrapping” method which makes use of the slight differences of the trades in each markets and profit from such small arbitrage opportunities. The extremely small profits are made up by massive volumes being trade. Even then, such trade are hardly risk-free, I think many of us will remember how Barings Bank failed. It was a well known and the oldest merchant bank in London, having originated from the German-origined Baring family. For those who claim that they can help you earn fast and easy money, take it not with a pinch of salt but with a gigantic lump of salt instead.

The significant increase in both the levels of market interest rates and volatilities since the late 1970’s had resulted in substantially higher interest rate risks faced by both businesses and financial institutions. These problems are compounded by the fact that most financial institutions and many corporations financed long-term fixed-rate assets with short-term floating-rate liabilities. The requirements for hedging against such risks led to the introduction and development of new financial products and derivatives of which interest rates swap are among the most popular due to the ease and simplicity of execution (Bicksler & Chen, 1985).

Before the introduction of the swaps, the only instruments available to borrowers were long-term fixed rate, long-term floating rate, and short-term debt. The combinations were as shown in Table 1. The introduction of the swaps especially when combined with short-term borrowing leads to the ability of the borrowers to fix the risk-free component of their interest rates while allowing the credit risk components to fluctuate and hence provide borrowers with previously unattainable alternatives that makes swaps a true and enduring financial innovation (Arak, et al., 1988).

Cross-currency basis swap rate between USD Libor and JPY Libor has fluctuated since the latter half of the 1990s, and it is increasingly important for the market players to figure out such swap rate movement. This is because while the pricing theory on cross-currency swaps was established and the basis swap market has been developed a long while ago, the factors in deciding such cross-currency basis swap rate in actual financial market are not well organized. In principle, the basis in such cross-currency swaps should be zero unless there are differences in credit risk embedded in the underlying reference rates of one currency relative to another. However in practical terms, the difference in the credits between the funding which are able to finance in USD Libor flat and JPY Libor flat differs according to financial conditions, demand and supply for swaps such as the differences in credit levels between the two Libor, demand and supply for cross-currency basis swaps and effect of foreign exchange market resulted in a far more complicated modelling than assumption of zero basis (Shinada, 2005).

To examine the functioning of the USD/JPY basis swap market, the effect of the Japan Premium must be taken into account. Pricing in the Euroyen market is based on LIBOR, the London Interbank Offered Rate, set at 11am London time or TIBOR, the Tokyo Interbank Offered Rate, set at 11am Tokyo time. Since the TIBOR panel is dominated by Tokyo city banks while the LIBOR panel is dominated by non-Japanese banks, the changing TIBOR-LIBOR spread reflects the credit risk associated with Japanese banks or the “Japan premium.” The spread was basically fluctuating about the zero point until 1995 but had an average of ten basis points from 1995 till 1999 (refer to Figure 1). The Japan premium briefly dissipated by the summer of 1999, but during the period of 1995 to 1999 there was a consistent premium of TIBOR over LIBOR (Covrig, et al., 2000).

The Japan Premium reflects the counterparty risk based on the Western bank’s belief that the Japanese banks have a higher risk of default especially in the dollar market. in particular, the dollar liquidity was a concern at the time of the 1997 and 1998 crisis. The Japan Premium is defined here as the differences between the interbank Euroyen quoted by the Japanese Banks and the average of the rate quoted by the non-Japanese banks in the Euroyen LIBOR samples. However since the spring of 1999, Japanese Banks had paid cash collaterals in interbank transaction. Default risk is therefore no longer reflected in the Japan Premium and the dissipation of the Japan Premium was due to the collateral rather than a dissipation of the risk (Hutchison & Westermann, 2006).


Arak, M., Estrella, A., Laurie, G. & Silver, A., 1988. Interest Rate Swaps: An Alternative Explanation. Financial Management, 17(2), pp. 12-18.

Bicksler, J. & Chen, A. H., 1985. An Economic Analysis of Interest Rate Swaps. The Journal of Finance, 28-30 December, 41(3), pp. 645-655.

Covrig, V., Low, B. S. & Melvin, M., 2000. A Yen is not a Yen: TIBOR/LIBOR and the determinants of the ‘Japan Premium’ , s.l.: s.n.

Hutchison, M. M. & Westermann, F., 2006. Japan’s Great Stagnation:Financial And Monetary Policy Lessons for Advanced Economies. Cambridge: MIT Press.

Shinada, N., 2005. Actual factors to determine cross-currency basis swaps: An empirical study on US dollar/Japanese yen basis swap rates from the late 1990s. Development of Japan, pp. 1-14.

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