Your U.S.bank issues a one-year U.S.CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar)investment in two-year,fixed rate Canadian bonds selling at par and paying 7 percent annually.You expect to liquidate your position in one year.Currently,spot exchange rates are U.S.$0.78493 per Canadian dollar.

If you wanted to hedge your bank's risk exposure,what hedge position would you take?

Question

Your U.S.bank issues a one-year U.S.CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year,fixed rate Canadian bonds selling at par and paying 7 percent annually.You expect to liquidate your position in one year.Currently,spot exchange rates are U.S.$0.78493 per Canadian dollar.

If you wanted to hedge your bank's risk exposure,what hedge position would you take?

If you wanted to hedge your bank's risk exposure,what hedge position would you take?

Quizplus · Accepted Answer

The U.S. bank has issued a U.S. CD with a fixed interest rate of 5% for one year. Hence, there is a risk of interest rate increases. To hedge against this risk, a short interest rate hedge is required. As the Canadian bonds have a fixed interest rate of 7% for two years, there is also a risk of decline in the value of Canadian dollars with respect to U.S. dollars. Therefore, a short currency hedge is also required. So, the best option is to take a short interest rate hedge and a short currency hedge. Thus, option B is the correct choice.

Your USBank Issues a One-Year U