Question

You own a US company with borrowings from Switzerland. Over the next few months, your loan repayment of CHF 50 million is due. Given the foreign exchange market movements, you would like to minimise the impact on your cash outflow. Based on the following data, devise a suitable strategy. Evaluate your chosen strategy against suitable alternatives for a range of expected future spot rates.

Spot rate = 0.9888 CHF/USD

3 month forward rate = 3 month future rate = 0.9796 CHF/USD

Option Premia: Strike Price	Call Option	Put Option
0.9850	0.0108	0.0146
0.9900	0.0087	0.0175

Each option contract has a size of 125,000 Swiss Francs.

Answer 1

Alternative 1: No hedge

If no hedge is taken then borrower will be exposed to risk when USD deprciates against CHF as more USD will be needed to purchase CHF 50 mil when payment is due. Payoff will be as follows.

Spot Rate	$m
0.9738	51.35
0.9788	51.08
0.9838	50.82
0.9888	50.57
0.9938	50.31
0.9988	50.06
1.0038	49.81

Hence, this strategy is not recommended.

Alternative 2: Forward hedge

It will lock in the cost for the borrower. However, if USD appreciates against CHF, borrower still has to pay agreed USD to purchase 50 million CHF (i.e. 0.9796 CHF/USD or 1.0208 USD/CHF). Payoff will be as follows.

Spot Rate	$m (Spot)	$m (Forward)	Profit/Loss ($m)
0.9738	51.35	51.04	0.30
0.9788	51.08	51.04	0.04
0.9838	50.82	51.04	-0.22
0.9888	50.57	51.04	-0.47
0.9938	50.31	51.04	-0.73
0.9988	50.06	51.04	-0.98
1.0038	49.81	51.04	-1.23

As you can observe, when USD appreciates against CHF, borrower has to suffer losses due to pre locked in cost. This strategy is recommended when borrower expects USD to depreciate against CHF.

Alternative 3: Bear Call Spread

This strategy is useful when the borrower expects USD to depreciate against CHF. We are long on 0.9850 call and short on 0.9900 call.

Spot rate	Long Call (0.9850)	Short Call (0.9900)	Premium Paid ($m)	Premium Received ($m)	Profit/Loss ($m)	Profit/Loss ($m)	Net Profit/Loss ($m)
0.9738	Exercised	Expired	0.55	0.44	0.58	-	0.48
0.9788	Exercised	Expired	0.55	0.44	0.32	-	0.22
0.9838	Exercised	Expired	0.55	0.44	0.06	-	-0.04
0.9888	Expired	Expired	0.55	0.44	-	-	-0.11
0.9938	Expired	Exercised	0.55	0.44	-	-0.19	-0.30
0.9988	Expired	Exercised	0.55	0.44	-	-0.44	-0.55
1.0038	Expired	Exercised	0.55	0.44	-	-0.69	-0.80

As you can observe, borrower is in profit when USD depreciates but incurs losses when USD appreciates. However, here the loss is reduced compared to no hedge.