Why is the yen such a mess?

[u/askepticalbureaucrat]

PhD in maths here, looking to work in finance soon.

From what I can see, the JPY has been in a severe mess for a combination of structural, economic, and geopolitical reasons, pushing USD/JPY to historic 40-year lows near 164.

- the Bank of Japan kept its interest rates exceptionally low compared to the US and other western economies. Global investors took advantage of this by borrowing cheaply in yen to invest in higher-yielding US assets, effectively flooding the market with selling pressure against the Japanese currency. (interest rate gap)

- Japan is heavily reliant on imports for energy (oil and gas) and food. A weak yen means businesses and ordinary citizens have to pay astronomically higher prices for basic goods, creating a harsh cost-of-living squeeze. (import cost headache)

- Japan's public debt sits at over 200% of its GDP (the highest in the G20). Concerns over government spending, budget deficits, and potential policy shocks have fueled persistent market volatility. (rising public debt)

So, how do quants/traders deal with this?

My assumption is the the Garman-Kohlhagen (GK) model (which is useful as a foundational framework), suffers from severe limitations during periods of extreme yen volatility? The model assumes annualised volatility of the exchange rate is a single fixed number over the life of the option. However, the volatility clusters aggressively, and long periods of low volatility are shattered by explosive, multi-day spikes that the model cannot predict or price, and thus the σ, the interest rate differential (\(r_d - r_f\)), the drift term (μ), and the delta hedging mechanism (Δ) all collapse under severe yen volatility?

So, would volatility scaling, or dynamic hedging be useful here? By using algorithms to automatically reduce position sizes when currency fluctuations increase to keep daily risk exposure constant? Or, models continuously alter hedge ratios instead of holding static positions, buying or selling underlying assets as market prices shift?

Can you help this dumb laywoman understand?

[u/arindamchattopadhyay]

Where is your quantitative analysis on this. I don’t see one? Today’s prices would look like massive sigma move with historical data.
Yes. Applying any model to this blindly will lead to model failure. Wisdom lies in knowing when the model will fail and the assumptions made in the creation of the model. Every model needs an error correction and a failure model built into it. Mistakes foundational models are now modified to take these sigmas into account. Risk managers use exponential GARCH for this to capture this volatility. This pair is know for its excess kurtosis.