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If I am a Yen investor and want to buy USD asset and hedge the currency exposure, are these hedging costs a function of interest rate differentials between Yen and USD and by extension the spot and forward exchange rates?

Intuitively, I would think that a stronger USD would make hedging costs more expensive because of the cost of getting access to USD funding but currently, the USD has been weakening against the Yen and yet hedging costs are increasing?

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If USD 5Y bond is 3% and JPY 5Y bond is 0%, and you think you can profit by multinational exposure you can exchange your JPY for USD and buy and hold the US 5Y bond. You will gain 3% per year and you will have considerable FX risk and you will also expect those gains to diminish because the USDJPY FX rate will be forecast to fall...

If you want to hedge your FX exposure you will instead of doing a spot FX transaction do a cross-currency swap (XCS). As part of that derivative you essentially swap the higher USD IBOR rates back to lower JPY IBOR rates, and the FX transaction at the end of the 3Y is effectively pre-determined (hence why you now have no FX risk). Since forward FX rates are calculated through XCS instruments USDJPY FX will be forecast to decline over time.

In summary, the actual expected gain in JPY terms of your USD asset is related to the yield of the USD asset above US-LIBOR and the JPY/USD XCS basis.

When you look at FX markets you have the spot FX price and the XCS basis (which determine the forward FX prices). The dollar can weaken against the yen in spot terms but if the term structure of the JPY/USD XCS basis curve becomes more negative then these multi-national hedged exposures become more expensive.

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