As the risk manager for a large pension fund, you know that the investment staff is con- sidering a move to diversify the portfolio over the next six months by investing $900 million in Japanese government bonds. Although you like the investment profile of these securities, you are concerned that adverse foreign exchange rate fluctuations could re- duce or even eliminate the expected returns from owning the bonds. Consequently, you want to consider a hedge against this exposure using currency futures contracts.

a. Describe how a currency futures contract position could be employed along with the purchase of the bond in this situation to mitigate the risk exposure the risk manager is concerned with.

b. Explain what would happen to both the currency futures position and the underlying bond holding if the USD/JPY exchange rate moved up unexpectedly after you initi- ated the FX hedge transaction.