Problem:
You are in corporate treasury and the company has a foreign subsidiary in Japan. The Japanese subsidiary's earnings are in yen and each quarter corporate must translate those earnings to dollars. You are beginning a new quarter and are concerned about the volatility in the yen/$ exchange rate and its possible adverse effect on translated quarterly earnings.
You consult foreign currency exchange rates and note that the yen/$ spot ask quote is Y110.6825/$. The 90-day forward ask quote is Y110.4560/$. Based on the forward exchange rate information:
1. Assess the potential risk,
2. Construct hedge using options, and
3. Construct a hedge using currency exchange forward contracts.
In the hedge, identify your position from the corporate perspective (earnings translated into dollars) and the currency the hedge is in, i.e., sell yen forward, etc.