The Swiss Franc (CHF) is the official currency for Liechtenstein and Switzerland. It is also widely used in Büsingen, the German exclave. The currency is distributed by the Swiss National Bank and the following table illustrates the basic exchange rates for Swiss Franc and other currencies.
|Euro||US Dollar||GB Pound||Australian Dollar||Canadian
|Indian Rupee||Emirati Dirham||Chinese Yuan||Malaysian Ringgit
Exchange Rate: Swiss Franc per one US Dollar (12/6/2013)
Exchange Rate: Swiss Franc per one GB Pound (12/6/2013)
Causes of Daily Exchange Rate Fluctuations
While it is common for free-floating exchange rates to rise and fall with time, several factors are at hand that serves to influence the extent of these changes. Bilateral transactions and currency exchanges show the largest changes within the money market when compared to measures of effective exchange rates. This refers to the rate of exchange for one currency against a collection of currencies for other states often assessed according to the level of transactions done with each nation. It is imperative to acknowledge that these changes in the exchange rates are predominantly caused by fluctuations in the supply and demand of a particular currency in the FOREX. When more people demand a certain currency, its exchange rate will rise. Conversely, when supple surpasses demand, the reverse holds true and the exchange rate drops.
Inflation is a major determinant of the level of exchange rates for any currency. If inflation in Switzerland is comparatively lower than in other nations, then Switzerland exports become more valuable and the demand for Swiss Francs will increase to purchase Swiss products. In addition, foreign commodities become less valuable and so Swiss consumers purchase less imports. Consequently, states with lower inflation rates are inclined to experience higher value in their currency. Differentials in inflation complicate the situation. Differentials refer to the separate inflation status of different countries. For over the last five years, Switzerland, Germany and Japan have experienced low inflation levels while Canada and the United States have experienced high inflation rates.
Differentials in interest rates also affected the exchange rates within Switzerland. Exchange rates, inflation and interest rates are all closely interrelated. By maneuvering the interest rates, Switzerland Central Bank exerted influence over both exchange rates and inflation, and influencing these interest rates affected the Swiss Franc values. The higher interest rates provide lenders increased profits when compared to other states. Consequently, the Swiss higher interest rates catch the attention of foreign investment cause the exchange rate to get higher. The impact of higher interest rates was limited, however, when inflation in Switzerland was much higher than in her trade partners, or when other aspects constrained the Swiss Franc. The reverse behavior was also witnessed when the declining interest rates lowered the exchange rates.
Hedging Foreign Exchange Risk
There are several assumptions that will be made throughout the calculations:
- All transactions are done in US Dollars ($) and Swiss Francs (CHF)
- Al the dates used will represent the latest figures unless otherwise indicated.
- All percentages and rates used represent the current market rates being used from the different sources.
- Currency Futures
June CHF futures contract exchange rate on June 12, 2013= $ 1.08 /CHF
One CHF futures contract= CHF 125,000; expiration month of futures contract= June 2013
- Currency Option
Strike exchange rate for call or put on CHF =$1.08 /CHF ; Expiration month= June 2012;
Call premium =$0.0063/CHF (0.63 cents); put premium = $0.0090/CHF ;
One option contract = CHF 62,500;
- Money Market Interest Rates
Annualized 180-day U.S. deposit rate =5.50%; annualized 180-day U.S. borrowing rate=5.75%;
Annualized 180-day Swiss deposit rate= 5.65%; annualized 180-day Swiss borrowing rate=5.85%; current spot $/CHF (Rate as at June 12, 2013)=$0.9259.
The amount of US$ required for the futures (forward) hedge and money market hedge to realize CHF 625,000 in 180 days will be assured. Nonetheless, the US$ required for the option hedge will be influenced by the provisions in the option that can allow it to be exercised in the span of 180 days. This in turn depends on the spot exchange rate on the termination date in June 2013.
It is assumed that the actual $/CHF spot exchange rate as at June 12, 2013 was $0.9259.
- Cost of Futures Hedge
Amount of US$ required in 180 days = amount of futures contracts ´ CHF 125,000 ´ futures rate
= 5 ´ CHF 125,000 ´ $1.08 = $675,000
- Option Hedge
Total option premium ($)= number of option contracts ´ CHF 62,500 ´ call premium/CHF
= 10 ´ CHF 62,500 ´$0.0063=$3937.5
Option will be exercised since the exercise rate ($0.74) is smaller than the spot rate ($0.9259).
Total exercise price paid ($) = CHF 625,000 ´ $0.74= $462,500
Total payment in dollars to get CHF 625,000 = $3937.5 + $462,500 = $466, 437.5
- Money Market Hedge
Borrow the PV of CHF 625,000 in dollars on December 12, 2013; convert $ to CHF at the spot exchange rate; invest CHF in the Swiss market for 180 days; and repay the $ loan in 180 days.
PV of CHF 625,000 on Dec. 12, 2013= (CHF 625,000/1.02825)=CHF 607,828.83
Borrow CHF 607,828.83 in dollars for 180 days: CHF 607,828.83 ´ $0.9259=$562,788.713697
Convert $562,788.713697 to CHF @ $0.9259/CHF: CHF 607,828.83
Invest CHF 607,828.83 @ 2.825% for 180 days: CHF 607,828.83 ´1.02825=CHF 625,000
Repay $ loan @ 2.8750% in 180 days: $436,238.75 ´ 1.028750=$448,779.84
Total cost of money market hedge=$448,779.84
- No Hedge Situation
CHF 625,000 ´ 0.9259= $578687.5
Summary of Three Hedging Options
Cost of futures hedge = $449,375
Cost of money market hedge = $448,779.84
Cost of option hedge = $3937.5 +$406,250= $410,187.50.
Cost with no hedge = $406,250
From the above analysis, it is evident that the costs of the money market hedge and hat of the futures hedge are almost similar. However, the option hedge was slightly lower making it the ideal alternative. The other reason for this choice is that
In the comparison of a hedged position to that which is unhedged, the company should definitely hedge their investment. This is because the fluctuations that have been illustrated in the earlier analysis of the international exchange rates between the Swiss Franc and the American Dollar
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