Enhancing returns on yen: minimizing risk reversal costs

Abstract

Cash managers and other investors with excess Japanese yen could choose to invest in dollars and to use zero-cost currency options collars (or risk reversals) to limit fluctuations in the dollar-yen exchange rate (as illustrated by VanderLinden and Gramlich, 2005). However, traders know that there is a market-driven, time-varying cost to risk reversals that can reduce their effectiveness in hedging. This paper evaluates a decision rule to reduce the impact of risk reversal costs. This rule, based on a 30-day moving average of risk reversal costs, appears to minimize risk reversal costs when used with the dollar–yen exchange rate. Whether application of the rule significantly improves risk-adjusted returns is less clear.

Notes

¹ The general formula for the gain expressed in home currency (in this case the yen) is R_h  = (1 + R_f ) (1 + e) – 1, where R_f is the US dollar interest rate and e is the percentage change in the value of the dollar. In the case of currency options collars, e = (strike price/spot XR) – 1 when both are expressed in ¥/$. For our example, the maximum return in yen would be (1.0152) (108.54¥/$/106.50¥/$) – 1 = 3.5%.

² The transactions costs are assumed to be 5 basis points for the bid–ask spread (for converting at the spot exchange rate) and 4 basis points for entering into a zero-cost collar.

³ The reduction in volatility costs of 0.17% was applied to one trial of the 3-month strategy (once with the reduction, once without it) to try to assess the potential impact of this improvement. Details are available from the authors.