Question

The risk-free one-year interest rate in the Swiss Franc (CHF) is 1.5%, while the risk-free one-year interest rate in the Euro (EUR) is 3.5%. The current spot exchange rate is CHF 1.2000 = 1 EUR and both currencies are traded in an open market without transaction costs. Anyone can borrow or lend at the risk-free rate in either currency. Your Swiss client (whose wealth and profits are in Swiss Francs) has an obligation of EUR 10,000, six months from now. How can your client construct a money-market hedge, to fund this obligation without exchange-rate risk?

1)To begin with, what currency exchange (if any) needs to be made at the beginning?

A.Swiss Francs for Euro (i.e. sell CHF and buy EUR).

B.Euro for Swiss Francs (i.e. sell EUR and buy CHF).

C.No currency exchange needs to be made at the beginning.

2)How large a position in the EUR risk-free asset needs to be taken? Enter the number of Euro that need to be borrowed or lent. Round to the nearest cent, and do not enter a currency symbol.

3)What position needs to be taken in the CHF risk-free asset at the beginning?

		A.Borrowing.
		B.Lending.
		C.No position needs to be taken in the CHF risk-free asset.

4)How large a position in the CHF risk-free asset needs to be taken? Enter the number of Francs that need to be borrowed or lent. Round to the nearest Rappen (hundredth of a Swiss Franc), and do not enter a currency symbol.

5)What is the payoff from the Euro position at the end? Enter the number of Euro, round to the nearest cent, and do not enter a currency symbol. Distinguish between inflows and outflows here, by applying a negative sign to any outflows.

6)What is the payoff from the Franc position at the end? Enter the number of Francs, round to the nearest Rappen, and do not enter a currency symbol. Distinguish between inflows and outflows here, by applying a negative sign to any outflows.

7)What currency exchange (if any) needs to be made at the end?

		A.Swiss Francs for Euro (i.e. sell CHF and buy EUR).
		B.Euro for Swiss Francs (i.e. sell EUR and buy CHF).
		C.No currency exchange needs to be made at the end.

8)What is the effective exchange rate in this transaction? Enter this as the number of Swiss Francs that a Euro will cost the client effectively; round to four decimal places. If you believe that the effective exchange rate is uncertain (because future exchange rates are unpredictable) enter the number -1000.

Answer 1

You have asked a question with 8 sub parts. I have addressed the first four of them. Please post the balance questions separately.

1)To begin with, what currency exchange (if any) needs to be made at the beginning?

The correct answer is the first option i.e option A.Swiss Francs for Euro (i.e. sell CHF and buy EUR).

We have a payable in Euro and Euro has higher interest rate than the Swiss Francs. So, it makes sense to convert to Euro to begin with.

2)How large a position in the EUR risk-free asset needs to be taken? Enter the number of Euro that need to be borrowed or lent. Round to the nearest cent, and do not enter a currency symbol.

Position in the EUR risk free asset = PV of payable = Payable / (1 + Euro interest rate x time in years) = 10,000 / (1 + 3.5% x 6 / 12) =  9,828.01

3)What position needs to be taken in the CHF risk-free asset at the beginning?

The correct answer is the first option i.e. option A.Borrowing.

We borrow CHF, convert it into Euro at the beginning and lend the same.

4)How large a position in the CHF risk-free asset needs to be taken? Enter the number of Francs that need to be borrowed or lent. Round to the nearest Rappen (hundredth of a Swiss Franc), and do not enter a currency symbol.

Position in the EUR risk free asset = 9,828.01

The current spot exchange rate is CHF 1.2000 = 1 EUR

Hence, position in CHF = 9,828.01 x 1.2 =  11,793.61