Question

On July: On July 1, 2017, a company enters into a forward contract to buy 10 million Japanese yen on January 1, 2018. 1, 2017, a company enters into a forward contract to buy 10 million Japanese yen on January 1, 2018. On September 1, 2017, it enters into a forward contract to sell 10 million Japanese yen on January 1, 2018. Describe the payoff from this strategy.

Answer 1

The company's payoff from entering into two opposing forward contracts to buy and sell the same amount of Japanese yen on the same date is a forward-forward hedge that mitigates foreign exchange risk, effectively locking in an exchange rate and protecting against currency fluctuations.

Step-by-step explanation:

In the scenario described, a company is engaging in a forward contract strategy where it enters into two opposing forward contracts for the same amount and date involving Japanese yen. Specifically, the company agrees to both buy and sell 10 million Japanese yen on January 1, 2018. This strategy is known as a forward-forward hedge and is used to mitigate foreign exchange risk. The payoff from this strategy will depend on the exchange rate on the settlement date.

If the exchange rates on January 1, 2018, are such that the yen has appreciated against the company's domestic currency (assuming for example, USD), the company will make a gain on its purchase contract and a loss on its sale contract. These gains and losses will offset each other, effectively locking in the exchange rate that was in effect when the contracts were entered. This strategy removes the uncertainty around future exchange rate fluctuations, which can have a significant impact on the cost of transactions, especially in light of historical yen/dollar movements, as indicated by the various figures and statistics given, illustrating the volatility and potential threat to businesses from sharp shifts in the exchange rate.

Answer 2

The reward in this strategy will depend on the international price at which the Yen is placed in the purchase and sale periods.

Example:

If in July it enters into a contract to buy the 10 million Japanese Yen on January 1, 2018. At a price of 100 Yen per dollar.

Then in September the Yen does not cost 100 per dollar but it costs 108 Yen per dollar. Then I sell what I received in the first contract at a more expensive price and I will get a profit by exchange rate.