Question

Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative investments of EUR10,000,000. Either she will invest in euro deposits or she will invest in Swiss francs (CHF) for 90 days. In the latter case, she knows that she must worry about transaction foreign exchange risk, so she has decided to fully hedge her investment. Suppose she has the following data:180-day CHF interest rate, 8% p.a., 180-day EUR interest rate, 10% p.a., spot rate EUR1.1960/CHF, 180-day forward rate, EUR1.2024/CHF. Which of these deposits provides the higher euro return in 180 days? If these were actually market prices, what would you expect to happen?

Answer 1

The euro return to investing directly in euros is 180 5% 10% 360   = ×  ÷   , so the euros available in 180 days is EUR10,000,000 × 1.05 = EUR10,500,000. Alternatively, the EUR10,000,000 can be converted into Swiss francs at the spot rate of EUR1.1960/CHF. The Swiss francs purchased would equal EUR10,000,000 / EUR1.1960/CHF = CHF8,361,204. This amount of Swiss francs can be invested to provide a 180 4% 8% 360   = ×  ÷   return over the next 180 days. Hence, interest plus principal on the Swiss francs is CHF8,361,204 × 1.04 = CHF8,695,652. If we sell this amount of Swiss francs forward for euros at the 180-day forward rate of EUR1.2024/CHF, we get a euro

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return of CHF8,695,652 ×EUR1.2024/CHF = EUR10,455,652. This is less than the return from investing directly in euros.If these were the actual market prices, you should expect investors to do covered interest arbitrages. Investors would borrow Swiss francs, which would tend to drive the CHF interest rate up; they would sell the Swiss francs for euros in the spot foreign exchange market, which would tend to lower the spot rate of EUR/CHF; they would deposit euros.

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