Question

Consider a U.S.-based company that exports goods to Switzerland. The U.S. Company expects to receive payment on a shipment of goods in three months. Because the payment will be in Swiss francs, the U.S. Company wants to hedge against a decline in the value of the Swiss franc over the next three months. The U.S. risk-free rate is 2 percent, and the Swiss risk-free rate is 5 percent. Assume that interest rates are expected to remain fixed over the next six months. The current spot rate is $0.5974 a. Indicate whether the U.S. Company should use a long or short forward contract to hedge currency risk. b. Calculate the no-arbitrage price at which the U.S. Company could enter into a forward contract that expires in three months. c. It is now 30 days since the U.S. Company entered into the forward contract. The spot rate is $0.55. Interest rates are the same as before. Calculate the value of the U.S. Company’s forward position.

Answer 1

Answer:

a. U.S. Company should use a short forward contract to hedge currency risk.

b. $0.5931

c. A gain of $0.0456 is recognized by the company

Explanation:

a. As the company will receive settlement in Swiss francs in three months time, the currency risk is at the time of settlement receipt, Swiss francs will not be worth as much as it is expected against US dollar (or depreciated against USD). Thus, the company has to take the short position in forward contract to sell Swiss francs in three months time at predetermined rate.

b. We have F = S0 x ( 1+ USD rfr ) ^(90/365) / (1+ Swiss franc rfr) ^(90/365) = 0.5974 x 1.02^(90/365) / 1.05^(90/365) = $0.5931.

c. Value of the gain in the short position will be calculated at the time of 60-day-remaining to maturity as followed:

F at the beginning/ ( 1+ USD rfr) ^ (60/365) - Spot rate at the 60-day-remaining to maturity/ (1+ Swiss franc rfr) ^(90/365) = 0.5931/1.02^(60/365) - 0.55/1.05^(60/365) = $0.0456.