5. You own a US company with borrowings from Switzerland. Over the next few mont

Question

5. You own a US company with borrowings from Switzerland. Over the next few months, your loan repayment of CHF 50 million is due. Given the foreign exchange market movements, you would like to minimise the impact on your cash outflow. Based on the following data, devise a suitable strategy. Evaluate your chosen strategy against suitable alternatives for a range of expected future spot rates. Spot rate 0.9888 CHF/USD 3 month forward rate 3 month future rate0.9796 CHF/USD Option Premia: Strike Price 0.9850 0.9900 Call Option 0.0108 0.0087 Put Option 0.0146 0.0175 Each option contract has a size of 125,000 Swiss Francs.

Explanation / Answer

Our company is US based so USD is home currency. CHF is foreign currency. Borrowing is of CHF 50 million. As exact time of loan repayment is not given, we will assume that it is due at the end of 3 months. Expected future spot rates can be assumed to be:-

0.9750 CHF/USD

0.9888 CHF/USD

0.9950 CHF/USD

3 scenarios can be:-

1. Entering into forward contract at rate of 0.9796 CHF/USD. Payment at the end of 3 months will be:-

=Amount due in Foreign currency / exchange rate per unit of home currency i.e. CHF/USD

=50,000,000 / 0.9796 = 51,041,241 USD (rounded off)

2. The Option rate is in CHF/USD. As CHF is to be purchased at the end of 3 months, it means we have to sell USD, so we have to take Put option for USD. Two Strike prices are given, we can enter two contracts at both the strike prices, or based on our expectation, we can enter in any one contract. We are entering into only one contract at lower strike price of 0.9850 CHF/USD

Number of contracts required= Amount required / Size per contract = 50,000,000/125,000

= 400 contracts

Entering into put option at 0.9850 CHF/USD for premium of 0.0146

Premium paid= 0.0146 CHF x 50,000,000= 730,000 USD

Scenario one- Spot rate 0.9750 CHF/USD. Option will be exercised. Payment to be made:-

50,000,000/0.9750 = 51,282,051 USD plus 730,000 premium already paid. Total = 52,012,051 USD

Scenario two- Spot Rate 0.9888 CHF/USD. Option will not be exercised. Payment to be made:-

50,000,000/ 0.9888 = 50,566,343 USD plus 730,000 Total = 51,296,343 USD

Scenario three- Spot Rate 0.9950 CHF/USD Option will not be exercised. Payment to be made:-

50,000,000/ 0.9950 = 50,251,256 USD plus 730,000 Total = 50,981,256 USD

3. If no hedging is done, payment to be made at different spot rates will be:-

At 0.9750 CHF/USD = 50,000,000/0.9750 = 51,282,051 USD

At 0.9888 CHF/USD = 50,566,343 USD

At 0.9950 CHF/USD = 50,251,256 USD

Based on the above 3 strategies and the expectation of the company as to what will be the future spot rate from among the 3 scenarios mentioned above, the strategy to opt for is:-

If company expects future spot rate to be 0.9750 CHF/USD :- Enter Forward Contract

If company expects future spot rate to be 0.9888 CHF/USD :- No hedging/ Forward Contract

If company expects future spot rate to be 0.9950 CHF/USD :- No Hedging/ Option Contract

Not hedging the foreign currency transaction is never advisable and hence company should enter the option/ forward contracts as mentioned in scenario 2 and 3.

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