I'd welcome advice and suggestions from the options gurus here who have hands-on experience with exotics (I'm assuming exotics but if a plain-vanilla strategy can do the job, great). I want to hedge a loan (c. US$3.5mn) taken out in Yen, repaying quarterly on a floating reset basis at a set margin over cost of funds. Client's income stream/asset base is in US$. Loan will likely run for more than 5 years term. The interest rate differential advantage is presently around 4.75%. We have the option of switching the loan (at bid/offer cost) into US$ several times a year, so gradual shifts in fundamentals and dynamics aren't a problem. It's those nasty short-term major yen up moves. Is it feasible to hedge this cost-effectively with a low-maintenance structure (and one that doesn't have an inherent secondary risk that needs to be addressed if an event triggers the hedge in some way)? Is it 'better' to have a longer term expiry and close out/reestablish, or opt for qt'ly in line with payment cycle?
this is a carry trade that cannot be perfectly hedged unless you are willing to sacrify the interest rate differential. You will lose if the yen appreciates by more than this interest rate differential. If you try to hedge this with options via collars or other, the forwards used to price the hedge will eat away your carry, so no, no way you can hedge this and come on top. You have a trading position bullish dollar, the only thing you can do is trade around it with CME futures, i.e. do no nothing when $ strenghtens and sell $:yen when yen weakens. You need to have a clue about the direction of $:yen both on a short/medium and long term basis. Personnally, I wouldn't put this trade on at this point. BOJ may start hiking rates within a year and there is strong potential for unwind of carry trades. You could end up losing way more than the interest rate differential. Good luck
Thanks alexandre, but I'm not really seeking opinions on yen. Whilst there may be similarities to the archetypal hedge fund carry trade, the loan to asset value ratio is about 40%, and the asset itself might reasonably be expected to realise a total return of 10%+ in Year 1. What I'm exploring is the type of hedge a sophisticated corporate treasury dept. may employ. Some fluctuation of rates and erosion of the differential is acceptable. I have recently used standard collar-type strategies to successfully protect, and lock-in gains in other yen mortgages as the rate moves, using the CME's options (which are thinly traded and a killer on the b/o). But the size is smaller and the client more tolerant. There is no additional profit goal sought in this case; simply protection against a short-term significant move inflating the loan liability unmanageably.
I'd try wilmott.com. The quants there could probably give you a quick answer. Please post back how it can be structured if it can. I'm certainly up for more education. You might also try PM'ing RiskArb. He does barrier options on the Nikkei sometimes and has to manage his currency exposure. He mentioned it in passing in one of his journals a month back or so. Good hunting, Sam
Perhaps a long yen barrier risk-reversal, rolling it monthly. Long the +25d touch, long the -25d no touch. You could structure the trade with zero outlay, or a static +expectancy by taking some +deltas. A down and out call is an alternative.
Riskarb, much appreciated, I'll read up on that structure before asking any supp Q's. Thanks also, Sam, for reminding me re. Wilmott. I've also put it to a prime broker and will post any alternative suggestions