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Question

Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, 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.

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