You are the vice president of finance for Exploratory Resources, headquartered i

Question

You are the vice president of finance for Exploratory Resources, headquartered in Huston, Texas. In January 2010, your firm's Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $0.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The June 2010 contract (face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar.

a. Explain how the Houston bank could lose on this transaction assuming no hedging.

b. If the bank does hedge with the forward contract, what is the maxium amount it can loose?

Explanation / Answer

Part A)

The loan has been extended in Canadian Dollars by the bank in Houston and it will be repaid in the same currency (Canadian Dollars). The Houston bank could suffer a loss as a result of decline in the future price of Canadian Dollars (which is a possibility as indicated by the futures contract price) because the bank will get repaid in a currency having less worth at the time of repayment as compared to its worth when the amount was borrowed by the company.

_________

Part B)

The difference between the buying price ($.8995/CD) now and the selling price ($.8930) in the future is the maximum amount of loss that can be suffered by the bank. The formula for calculating loss can be derived as follows:

Maximum Loss = Value of Contract*(Buying Price - Selling Price)

_________

Using the information provided in the question, we get,

Maximum Loss = 150,000*(.8995 - .8930) = $975

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