Question

An FI is planning to hedge its one-year, 100 million Swiss francs (SFr)–denominated loan against exchange rate risk. The current spot rate is $1.10/SFr. A one-year SFr futures contract is currently trading at $1.08/SFr. SFr futures are sold in standardized units of SFr125,000.

1. Should the FI be worried about the SFr appreciating or depreciating?
2. Should the FI buy or sell futures to hedge against exchange rate risk exposure?
3. How many futures contracts should the FI buy or sell if a regression of past changes in the spot exchange rate on changes in the future exchange rate generates an estimated slope of 1.4?
4. Show exactly how the FI is hedged if it repatriates its principal of SFr100 million at year-end, the spot exchange rate of SFr at year-end is $1.05/SFr, and the forward exchange rate is $1.0443/SFr.

Answer 1

a) The FI should be worried about SFr appreciating, as the loan is denominted in SFr and as the value of SFr appreciates, FI will have to make more outflow of $.

b) FI should buy futures to hedge the risk of change in exchange rate as it will be paying off SFr denominted loan.

c) No. of contracts to be bought:

(SFr 100 million/ SFr 125000) × 1.4 = 1120 contracts
  
  

d) Hedging of loss under forward cover:

$ value of loan at the time of repayment $ 105 ml

( $1.05× SFr 100 million)

Repayment under Forward cover - $ 104.43 ml

( $ 1.0443× SFr 100 million)

Hedged amount $ 0.57 ml