IRP and forward premium and discount

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shrubaks123

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Hi,
Suppose you are US resident (Short term Interest rate 3%) and want to invest in YEN (Short term interest rate is 5%) and
In IRP calculation we determine forward premium as +2% which means if you lock in today the forward premium then you will be indifferent for investing between Japan and USA. This also means if you invest in Japan then japanese currency will increase 2% during the entire hedge period. My questions are
1. In order to hedge japanese currency in the given example what forward contract do you enter into?
2 And if suppose in this example Japanese currency was at a discount then what forward contract do we enter into?
 
If your local currency is USD and you want to insure against a decrease in the USD/JPY exchange rate, you will enter into a forward contract to receive USD and pay JPY at a known exchange rate. Whether the JPY is trading at a forward premium or a forward discount doesn’t matter: your position in the forward contract is the same either way.
 
S2000magician wrote:
If your local currency is USD and you want to insure against a decrease in the USD/JPY exchange rate, you will enter into a forward contract to receive USD and pay JPY at a known exchange rate. Whether the JPY is trading at a forward premium or a forward discount doesn’t matter: your position in the forward contract is the same either way.
Click to expand...
Ok, you have me confused. If USD is your home currency, wouldn’t the USD/JPY decrease be a good thing meaning the Dollar appreciated against the Yen? In your statement, are you saying “insure against a depreciation in the USD/JPY exhange rate”? Thanks.
 
I’d buy Willa Cather a beer wrote:
S2000magician wrote:If your local currency is USD and you want to insure against a decrease in the USD/JPY exchange rate, you will enter into a forward contract to receive USD and pay JPY at a known exchange rate. Whether the JPY is trading at a forward premium or a forward discount doesn’t matter: your position in the forward contract is the same either way.
Click to expand...
Ok, you have me confused. If USD is your home currency, wouldn’t the USD/JPY decrease be a good thing meaning the Dollar appreciated against the Yen? In your statement, are you saying “insure against a depreciation in the USD/JPY exhange rate”? Thanks.
Click to expand...
If you have an investment in JPY and USD is your home currency, you want to get as many USD for each JPY as you possibly can. If the USD/JPY exchange rate decreases, you get fewer USD for each JPY.
That’s bad.
 
Thanks for clarifying. This currency reading has always confused me and I constantly have to remind myself that, even though your home currency may be The Dollar, an investment in a foreign market is composed of two parts, the foreign asset and the foreign currency.
 
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