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Hedging a Dollar Yen Forex Trade

Hedging a dollar yen forex trade can make sense if your foreign currency investments aren t very volatile. In this article, we ll explore the process of hedging in a real world example. IBM, a multinational corporation, purchased computer chips from a Japanese electronics company, NEC. It was billed Y250 million payable in three months. Currently, the spot exchange rate is Y105/$ and the three-month forward rate is 110 yen per dollar. Both rates are below the three-month money market interest rate in Japan. In this case, IBM decided to use a money market hedge to deal with the yen account payable. IBM management explained how the hedge worked, and conducted a cash flow analysis.

One way to hedge a dollar yen forex trade is to purchase foreign currency options. These options grant the buyer the right to purchase or sell a currency pair at a future exchange rate. Regular options strategies are also available to limit a trade s losses. Ultimately, the main purpose of forex hedging is to protect profits. However, the costs of hedging outweigh the benefits after a certain point.

Strip hedging involves converting a floating-rate loan into fixed-rate payments. The fixed rates are calculated by adding 200 basis points to the discount yield of three Eurodollar futures contracts. If the LIBOR term structure remains flat for the first year, the fixed payments will be equal. Similarly, strip hedges are used when a currency trade is more volatile than expected. Traders can take advantage of this by selling fixed-rate currency in the short term.

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