Hi everyone - I'm a relative newcomer to the world of Forex and am hoping you could help me think through whether I have the right idea about how to protect a carry trade position using options.
Supposing you put on a carry trade with the sole objective of profiting from the interest rate differential. Let's say, for example, you put on a long NZD/JPY position. According to OandA, the lending interest rate on NZD is 8% and the borrowing rate on JPY is 0.25%, meaning the interest return on the trade is 7.75%. Let's say that your tolerance for risk in putting on this trade is very low, i.e. all you care about is getting that 7.75% and you are concerned about guarding against the downside than creating upside potential.
The primary risk here is that if the Yen strengthens significantly it can wipe out the profits you make from interest. I'm wondering if you could use FX options to protect yourself against this. From what I can gather, a NZD/JPY put option (i.e. the right to sell NZD and buy JPY at a fixed rate when the options expire) with a strike price equal to the price of your position that expires when you plan to close your position would achieve this. If, when you close your position, the Yen has strengthened, you exercise the option and the return offsets the loss created by closing the currency position, otherwise it expires worthless. If this is the case, then the only risk you face is converging interest rates. Obviously if the Yen weakens, you've profited from holding the position and don't need to worry about the option.
Assuming that the scenario I've sketched out above makes sense, I'd appreciate comments on how to:
a) establish how much such an option would cost, and
b) execute this trade in practice
Thanks in advance for any pointers!
Supposing you put on a carry trade with the sole objective of profiting from the interest rate differential. Let's say, for example, you put on a long NZD/JPY position. According to OandA, the lending interest rate on NZD is 8% and the borrowing rate on JPY is 0.25%, meaning the interest return on the trade is 7.75%. Let's say that your tolerance for risk in putting on this trade is very low, i.e. all you care about is getting that 7.75% and you are concerned about guarding against the downside than creating upside potential.
The primary risk here is that if the Yen strengthens significantly it can wipe out the profits you make from interest. I'm wondering if you could use FX options to protect yourself against this. From what I can gather, a NZD/JPY put option (i.e. the right to sell NZD and buy JPY at a fixed rate when the options expire) with a strike price equal to the price of your position that expires when you plan to close your position would achieve this. If, when you close your position, the Yen has strengthened, you exercise the option and the return offsets the loss created by closing the currency position, otherwise it expires worthless. If this is the case, then the only risk you face is converging interest rates. Obviously if the Yen weakens, you've profited from holding the position and don't need to worry about the option.
Assuming that the scenario I've sketched out above makes sense, I'd appreciate comments on how to:
a) establish how much such an option would cost, and
b) execute this trade in practice
Thanks in advance for any pointers!
