Hedging Strategies

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Call options on euros are available with an exercise price of $1.15, an expiration date of one year from today, and a premium of $0.08 per unit. Required: a) Identify the risks of each strategy and estimate the dollar cash flows it will receive as a result of using each strategy. To do so you must consider a number of different exchange rate outcomes at the end of one year ranging from the dollar depreciating to the dollar appreciating against the euro. (10 marks) b) Explain which hedge you think is optimal for ABC. (5 marks) Continuous Assessment: Individual Assignment must be submitted in hard copy and via Blackboard. See the Continuous Assessment: Individual Assignment deadline in table 2B above. It is the student's responsibility to retain a copy of any submitted assessment work. Please read the Grade Descriptors in the Assignment Grade Descriptor table. VO? 4G+ 1 92% i 5:43 pm BBS50 TRM Study Guide - Read-only IC Sign in to edit and save changes to this file. 2. Continuous Assessment: Individual Assignment For Question 1, there should be a brief introduction, the body of the answer and a conclusion section. Students are expected to write clearly and concisely, with appropriate in-text citation and references provided (Harvard system). 20 This assignment is designed to test students on topics involving hedging strategies. In Question 1, students are expected to research on the Swiss National Bank's intervention in the foreign currency market. In both questions, the emphasis is on analytical thinking to assess the effectiveness and implications of the hedging strategies. Question 1 (15 marks) In January 2015, the Swiss National Bank (SNB) suddenly announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro. The franc was pegged at 1.2 Swiss francs per euro from 2011 to 2015. A day after de pegging, the franc's value had fallen to just 0.85 francs. Hedge funds across the world made big losses. The Swiss stock market collapsed. Required: Discuss the reasons for the SNB de-pegging the franc and evaluate the hedging strategies implemented by the Swiss exporters and other domestic firms. Word count requirement: 800. Question 2 (15 marks) US-based company ABC Co. expects to receive a 50 million euro payment from its various exports one year from now. However this payment may rise to 60 million or fall to 40 million euro. ABC can use any one of the following strategies to deal with the exchange rate risk. (0) (ii) (iii) (iv) Unhedged strategy Forward hedge strategy Money market hedge Option hedge The spot rate of the euro as of today is $1.10 and the 1-year forward rate is $1.13. The annual interest rate in the United States is 5.5% versus an annual interest rate of 2% in the euro zone. The forward rate quoted to ABC does not necessarily satisfy interest rate parity (perhaps ABC's bank added in commission costs). Put options on euros are available with an exercise price of $1.11, an expiration date of one year from today, and a premium of $0.06 per unit.
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Introduction
De-pegging of currency means removing the previously instituted peg on the currency (Shapiro &
Moles, 2014). The Swiss Franc was pegged against from 2011 to 2014. In 15 January 2015, the
Swiss National Bank (SNB) unexpectedly undertaken decision to de-peg the Swiss Franc. This depegging of the Swiss Franc caused to decline of the value of Swiss Franc substantially. There was
some reasons of the de-pegging decision of SNB. The Swiss exporters and other domestic firms
required to consider some hedging strategies to minimize the economic risk exposure created from
appreciation of Swiss Franc.
Reasons for De-Pegging of Franc
The de-pegging of a currency make a fixed exchange rate regime to a floating exchange rate regime
(Stonehill, Dunning, & Moffett, 2014). The possible reasons of the de-pegging of the Swiss Franc
by the Swiss National Bank (SNB) are provided below.
(a) Requirement to maintain lower currency reserve: De-pegging of Franc will require to maintain
lower amount of reserve by SNB than earlier. Pegged exchange rate system requires to maintain
large amount of currency reserve (to constantly buy and sell the foreign currency) (Stonehill,
Dunning, & Moffett, 2014). The problem with huge amount of currency reserve is the unwanted
inflation (Sercu, 2014). Switzerland has already accumulated huge amount of foreign-exchange
reserve (The Economist, 2015). This huge foreign-exchange reserve will eventually lead
hyperinflation in the Swiss economy.
(b) Introducing ā€˜quantitative easingā€™ by Europe and the requirement to Print Paper money to
maintain peg: European Central Bank is expected to introduce ā€˜quantitative easingā€™ to retire
government debts. Quantitative easing will push down the euro value (The Economist, 2015). In
that case, SNB will require to print more francs for maintaining the peg (Eun & Resnick, 2010).
(c) Discretion of exchange to promote export: Depreciation of the Euro caused depreciation of
Franc as well in 2014 (12% against US dollar and 10% against Indian Rupee) (The Economist,
2015). A cheaper Franc boosted exports to American and India. The policymakers have realized
the need of discretion in own monetary policy (The Economist, 2015).

(d) Allowing better focus on monetary policy and inflation: Pegging the Swiss Franc against Euro
means that the national monetary policy of Switzerland began to reflect the monetary policy of
Europe. The Switzerland needs to have interest rate that reflect that of Europe during the time of
pegging the Swiss Franc (Waugh, 2016). During internal recession, Switzerland may requi...


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