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Question

A U.S. bank issues a 1-year, $1 million U.S. CD at 5 percent annual interest to finance a C $1.274 million investment in 2-year fixed-rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in 1 year upon maturity of the CD. Spot exchange rates are US $0.78493 per Canadian dollar.

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

A. A short interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

B. A short interest rate hedge to protect against interest rate increases and a short currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S. dollar.

C. A long interest rate hedge to protect against interest rate increases and a long currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S. dollar.

D. A long interest rate hedge to protect against interest rate declines and a long currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

E. A long interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

Answer

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