Question

1. Suppose the annualized interest rate on 180-day SFr deposits is 4.01%-3.97%, meaning that SFr can be borrowed at 4.01% and lent at 3.97%. At the same time, the annualized interest rate on 180-day CAD deposits is 8.01%-7.98%. Spot and 180-day forward quotes on CAD are $0.6433-42/SFr and $0.6578-99/SFr, respectively. You, as the financial manager of Air Canada, are trying to decide how to go about hedging SFr80 million in ticket sales receivable in 180 days.
   1. If hedging with forward contract, what would you do? What is the hedged value of Air Canada’s ticket sales?
   2. You may also want to consider the money market (by borrowing and lending) to lock in a future dollar value of Air Canada’s ticket sales. What would you do if this method is used? What is the hedged value of Air Canada's ticket sales in this case?
   3. Compare the strategies used in a) and b). Which strategy is preferable in this problem?
   4. Suppose the expected spot rate in 180 days is $0.67/SFr. Should you hedge? What factors should enter into your decision?
   5. Is there an arbitrage opportunity here? If there is an arbitrage opportunity, describe it.

Answer 1

a) In hedging with forward contract, we will agree to sell SFr80 million in ticket sales receivable in 180 days in the forward contract today. The rate fixed will be $0.6578/SFr

The hedgd value in CAD = SFr80 million * $0.6578/SFr= CAD 52.624 million

b) In money market hedge, SFr will be borrowed today in such a way that after 6 months, the amount exactly equals SFr80 million. The borrowed amount will be converted today to CAD and invested in Canada.

Amount borrowed today = 80/(1+0.0401*180/365) = SFr78.44865 million

Amount converted to CAD today = SFr78.44865 million *   $0.6433/SFr = $50.46602 million

This amount is invested at 7.98% for 180 days and final amount in $ receivable after 180 days = 50.46602*(1+0.0798*180/365) = $52.45203 million

Hedged value in this case is CAD 52.45203 million

c) The forward contract is better and preferable as the hedged value in Canadian Dollar is higher. Strategy used in a) is preferable

d) If the expected spot rate in 180 days is $0.67/SFr , the expected value of receivables in Canadian Dollar

= SFr80 million * $0.67/SFr= CAD 53.60 million

In this case, the hedging does not seem suitable. However, the expected exchange rate may not occur and hence it is still advisable to hedge at least some part of the exposure