In 1990, a Japanese investor paid $100 million for an office building in downtown Los Angeles. At the time, the exchange rate was ¥145/$1. When the investor went to sell the building five years later, in early 1995, the exchange rate was ¥85/$1 and the building’s value had collapsed to $50 million.
- What exchange risk did the Japanese investor face at the time of his purchase?
- How could the investor have hedged his risk?
- What exchange risk did the Japanese investor face at the time of his purchase?
Answer. The risk is that the value of the dollar would fall against the yen and that the dollar revenues would not keep up with the decline in the value of the dollar.
- How could the investor have hedged his risk?
Answer. The investor could have financed his purchase of the building by borrowing dollars, so that the very same event that led to a decline in the yen value of his asset–namely, a dollar decline– would simultaneously reduce the yen cost of the liability used to finance that asset. He could also have taken out a long-dated forward contract to hedge the yen value of his building. Nothing would have protected the investor from the decline in the building’s dollar price.
