Locking in a risk-free rate given exposure to two different currencies

CFA Level III Derivatives
#1

A portfolio is exposed to the U.S. bond market and both the U.S. and Japanese equity markets. How do you a lock in a US free rate?

The answer given is - hedging the Japanese equity portfolio and the currency risk between the dollar and the yen would lock in the U.S. risk-free rate.

How does that work?

#2

To hedge the Japanese equity portfolio, enter into a receive fixed, pay equity swap. To lock in the US risk-free rate, enter into a fixed-for-fixed JPY/USD currency swap (paying JPY, receiving USD).

1 Like
#3

Trying to figure out how doing that locks in the US free rate:

  • The equity swap removes the exposure to Japanese equity, leaving us with receiving fixed JPY interest
  • The currency swap removes the fixed JPY interest from equity swap as well any currency exposure on the JPY thus leaving us with receiving fixed USD RF rate?
#4

Yes and yes.

#5

Thanks!!