To benefit from the low correlation between the Swiss Franc (CHF) and the Japane

Question

To benefit from the low correlation between the Swiss Franc (CHF) and the Japanese yen (JPY), Smith Corporation decides to borrow 50% of funds needed in CHF and the remaining 50% in JPY. The domestic U.S. financing rate for a one-year loan is 7%. The Swiss one-year interest rate is 6% and the Japanese one-year interest rate is 10%. Smith has determined the following possible percentage changes in the two individual currencies as follows:

Currency

Percentage Change

Probability

Swiss Franc

2.0%

30%

Swiss Franc

4.0%

70%

Japanese yen

-3.0%

60%

Japanese yen

1.0%

40%

What is the expected effective dollar financing rate of the portfolio Smith is contemplating (assume the two currencies move independently from one another, in other words Corr = 0)?

Currency

Percentage Change

Probability

Swiss Franc

2.0%

30%

Swiss Franc

4.0%

70%

Japanese yen

-3.0%

60%

Japanese yen

1.0%

40%

Explanation / Answer

Expected change in Swiss Franc =2.0*.30+4*.70

   =3.4%

Expected change in JAP.Yen =-3*.60+1*.40

= -1.4%

Effective SF Rate is 7%+3.4% =10.4 %

Effactive JYP Rate is 10%-1.4 =8.6%

as both has equal weights 10.4+8.6/2

=9.5%

     

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