A U.S.bank issues a 1-year, $1 million U.S.CD at 5 percent annual interest to finance a C $1.274 million investment in 2-year fixed-rate Canadian bonds selling at par and paying 7 percent annually.You expect to liquidate your position in 1 year upon maturity of the CD.Spot exchange rates are US $0.78493 per Canadian dollar. If you wanted to hedge your bank's risk exposure, what hedge position would you take?
A)A short interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S.dollar.
B)A short interest rate hedge to protect against interest rate increases and a short currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S.dollar.
C)A long interest rate hedge to protect against interest rate increases and a long currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S.dollar.
D)A long interest rate hedge to protect against interest rate declines and a long currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S.dollar.
E)A long interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S.dollar.

Question

Quizplus · Accepted Answer

A short interest rate hedge is needed to protect against interest rate increases, as this would cause the value of the CD to decrease in the market. A short currency hedge is also needed to protect against declines in the value of the Canadian dollar with respect to the U.S. dollar, as the investment in Canadian bonds would lose value if the Canadian dollar weakened.

A USBank Issues a 1-Year, $1 Million U