Suppose that you (i.e., company XYZ) are a US-based exporter of goods to Switzer
ID: 2634996 • Letter: S
Question
Suppose that you (i.e., company XYZ) are a US-based exporter of goods to Switzerland. You will be receiving payment on a shipment of imported goods (CHF100,000) in three months and want to hedge your currency exposure. The US risk-free rate is 6% and the Switzerland risk-free rate is 4% per year. The current spot rate is $1.1/CHF, and the three-month forward rate is $1.2/CHF. You can also buy a three-month option on CHF at the strike price of $1.25 /CHF for a premium of $0.05/CHF.
1.If XYZ enters a forward contract today, the guaranteed dollar proceeds for this CHF obligation in three months should be $?
2.If XYZ wants to hedge the transaction exposure using money market hedge, XYZ should ______________.
A) borrow PV of CHF and buy USD today, and deposit USD in the bank and sit on it.
B) buy PV of CHF today using USD, and deposit CHF in the bank and sit on it.
3.If XYZ uses MMH, the guaranteed dollar proceeds in three months should be $?
4.By comparing forward hedge and money market hedge, which strategy (forward/MMH) would you prefer to use?
Explanation / Answer
US risk free rate = 6%
Switzer land risk free rate =4%
Spot rate $/CHF = 1.1
Three month forward rate ($/CHF) =1.2
Three month call option (Strike $/CHF = 1.25) =$0.05/CHF
Expected rate after 3 month (Interest rate Parity) = 1.1*(1+06*0.25)/ (1+04*0.25) = 1.375
Cost of borrow = 100000*0.04*0.25 = 1000 CHF
USD Bought =1.1*100000 =110000
USD Value after three month with interest = 110000(1+0.06*0.25) = 111650
USD required at the end of three month to pay the borrow cost of 1000 CHF =1000/1.375 =727.2727273
Net USD Proceed after 3 months = 111650-727.2727273=110922.7273
As borrowed CHF will be paid back by the CHF receipt after 3 month for the payment of shipment goods
Case 2 (Net proceed) : Buy CHF using USD and deposit CHF
USD Required to buy 100000 CHF =100,000*1.1 =110000
Cost of borrow for USD = 110000 *0.06*0.25 = $1650
CHF value after three month with interest = 100000*(1+0.04*0.25) = 101000
USD Value after 3 month when CHF converted to USD = (101000( borrowed) +100000(payment for imported goods))*1.375 =276375
Net USD Proceed after three months = 276375- 1650(cost of borrow)-110000 (borrowed USD)
=$164725
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