Question

Hedging Strategy:
ED is a Europe-based company. ED has decided to issue 1-year corporate bonds of 10 million EURO principal with a coupon payment of 3.5% p.a. The coupon is paid annually. The bond will mature on 30th June 2021 (treat this as exactly 1 year from today). Since the company will mainly draw their income from China over the coming year, ED’s managers are worried about exchange rate risks.
To ensure the company can pay off this debt, you are asked to provide a recommendation on the hedging strategy for the company. You should consider all possible hedging strategies. (The company pays the principal and the coupon upon maturity).
The current market information is below:
Spot rate CNY/EUR:           7.650 – 7.665
One-year forward rate CNY/EUR:   7.675 – 7.705
One-year in-house forecast of spot rate CNY/EUR: between 7.695 and 7.755
One -year interest rate EUR p.a.: 1.75% - 1.85%
One-year interest rate CNY p.a.:    2.25% - 2.50%

The European options on HKEX are quoted as:
One-year call option on EUR:
Exercise price = 7.7 CNY/EUR, Premium = 0.1633 CNY
One-year put option on EUR:
Exercise price = 7.8 CNY/EUR, Premium = 0.1732 CNY

Answer 1

SInce the company has issued a bond in Euro and its revenue is in Yuan, the risk to the company stems from the CNY depreciating against the Euro over the year

Since the company's in house forecast is for the CNY to depreciate more against the Euro in one year compared to the prevailing 1y CNY/EUR forward rate, the company should consider hedging its Yuan inflows.

The company can hedge its exposure either through forwards or through options.

If the Company enters into a contract to buy Euro 1y forward against the CNY, it would lock in a rate of 7.7050 Yuan Per 1 Euro

If the company decides to buy a call with a 7.7 strike, it would end up locking a rate of 7.7+.1633 = 7.8633 if CNY/EUR is above 7.7 after 1 year. However in this case the company would stand to benefit if the Yuan appreciates against the Euro over the year as the company would then not exercise its call option. For example, if the CNY/EUR is at 7.4, the company would end up effectively buying Euro at 7.4 + .1633 = 7.5633 (SInce the option premium paid is a sunk cost)

Since the company's internal forecast does not see the Yuan appreicating, it is better off going in for a forward contract to Buy Euro against CNY one year ahead. It would need to buy 10m * 1.035 = 10.35mn Euros forward to cover the risk of its pricipal + interest amount.