Investing with (FX) options: Hedging USD portfolios against USDJPY currency risk Investing with (FX) options: Hedging USD portfolios against USDJPY currency risk Investing with (FX) options: Hedging USD portfolios against USDJPY currency risk

Investing with (FX) options: Hedging USD portfolios against USDJPY currency risk

Options 10 minutes to read
Koen Hoorelbeke

Options Strategist

Summary:  This article explores the use of FX options as a hedge against currency risk in USD-denominated portfolios, focusing on the effects of a declining USDJPY rate. It presents a detailed example to demonstrate how investors can shield their investments from adverse currency movements, offering clear insights into managing currency fluctuations and the benefits of strategic hedging.


Hedging USD portfolios against USDJPY currency risk

Introduction

For investors with significant holdings in USD-denominated assets, the challenge of currency fluctuations, especially when the USDJPY rate declines, is a key concern. Safeguarding the value of these investments from such fluctuations is crucial. This article demonstrates the effective use of FX options as a hedge against this specific currency risk, focusing on the mechanics and outcomes of using these financial instruments to protect a USD-heavy portfolio.

Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

 

Initial Position

  • Investment/portfolio: A Japanese investor converts ¥14,780,000 into USD for investing in the US stock market (or has already existing holdings in USD with a value of $100,000.-).
  • Exchange rate: The current USDJPY rate is 147.8, so the investor gets, or value corresponds to $100,000 (¥14,780,000 / ¥147.8).

Impact of Currency Fluctuations

  1. Japanese yen strengthens (USDJPY rate decreases to 135, for instance)

    • Effect on investment: If the investor's USD holdings remain at $100,000, converting back to JPY at this rate would result in ¥13,500,000 ($100,000 * ¥135). This is a loss compared to the initial investment in JPY.
    • Outcome: The investor incurs a loss in JPY terms due to the strengthening of the JPY
       
  2. USD Strengthens (USDJPY Rate Increases)

    • Example: If the exchange rate changes from ¥147.8 to ¥155, for instance.
    • Effect on investment: Converting $100,000 back to JPY at this rate would yield ¥15,500,000 ($100,000 * ¥155), more than the initial investment.
    • Outcome: The investor gains in JPY terms due to the weakening of the JPY.

Complete Portfolio Hedging Example with FX Options

Context:

  • Portfolio value to hedge: $100,000
  • Objective: Hedge against the risk of USDJPY declining to 135.

FX Option Details:

  • Current USDJPY Exchange Rate: 147.8
  • Anticipated risk scenario: USDJPY declines to 135.
  • Alternate scenario: USDJPY appreciates or remains unchanged.
  • Put option specifics:
    • Strike price: 147 JPY per USD
    • Option premium: 5.566 JPY per USD
    • Nominal value of option: $100,000
    • Expiration date: 25th July 2024 (6 months from now)
    • Total premium paid: 556,600 JPY

Hedging strategy execution:

  • Action: Purchase put option(s) on USDJPY with a total premium cost of 556,600 JPY to cover $100,000.

Scenarios and financial outcomes:

  • Scenario - USDJPY declines to 135:
    • Without hedging: The $100,000 portfolio converts to ¥13,500,000 at this rate, resulting in a significant loss due to currency fluctuation.
    • With hedging: Exercise the put options to sell $100,000 at the strike rate of 147, achieving ¥14,700,000. The net gain from hedging, after the premium, is ¥643,400 (calculated as the profit from the option exercise of ¥1,200,000, which is ¥14,700,000 - ¥13,500,000, minus the premium paid of ¥556,600, resulting in ¥643,400).
  • Scenario - USDJPY appreciates or remains unchanged:
    • Portfolio value: The value of the USD portfolio in JPY terms increases or remains stable.
    • Put option(s): These options expire worthless.
    • Financial outcome: The loss is confined to the premium paid for the options, totaling 556,600 JPY.

Conclusion

Effectiveness of hedging: If USDJPY declines to 135, the strategy significantly reduces the currency risk. The net loss after hedging is ¥636,600, far lower than the ¥1,280,000 loss that would occur without hedging.

Cost of hedging
: If the USDJPY does not decline, the cost of the hedge is limited to the premium paid, which is 556,600 JPY. 

Overall financial outcome
: This example shows the potential results of using FX options for currency risk hedging. It emphasizes the importance of balancing potential loss reductions against the costs in less favorable or stable market conditions. While this article focuses on a basic hedging approach, more advanced strategies could optimize the hedge further, but exploring these is beyond its scope.

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