Enhancing returns on yen: minimizing risk reversal costs

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.