Investing in Japanese assets, and the currency? The Japanese equity and bond markets are full of opportunities. Asset-allocation models often show these markets lagging behind and offering potential for future growth. Given the weak fundamentals of the economy and the low interest rate environment, it requires guts to follow blindly the outcome of asset-allocation studies. Looking at the last five years, an investment in Japanese assets was not always the most profitable decision to be made. The future could be different, given the possibility of lower income tax for Japanese people. The new Japanese year could shrug off some painful incidents of the past.

When investing in Japanese assets, a decision has to be made about the currency exposure (if any). The value of the yen versus the major currencies is not stable. Currency exposure could be hedged in a passive way or via a more dynamic approach. Both approaches have to be directed by the currency benchmark of the investor. This benchmark usually varies per currency (block) and ranges from 100% hedged positions to no hedge at all. The dynamic approach allows a more frequent adjustment of the hedge ratio around the benchmark, triggered by a trend in the yen versus the base-currency. If the yen goes up, you reduce the hedge; if the yen goes down, you increase the hedge. This looks very simple. The difficulty of course is spotting trends at an early stage. This can best be done by using a high frequency tick-by-tick database, which contains second-by-second information on the prices of liquid currencies. Studies show that statistical arbitrage opportunities exist, allowing investors to effectively hedge their foreign exchange risk or invest in currencies, while enhancing the total return. Dynamic hedging is a time-consuming activity and can best be done on a 24-hour basis. In this context, specialist currency overlay managers are able to help.

Haijo Dijkstra and Bastiaan Dijkman are with Rabo Olsen Global Overlay Strategies in Utrecht