Swiss National bank Assignment Analysis

Assignment-Option Pricing
Question 1
Introduction
In January, 2005 the Swiss National bank announced that the bank would no longer hold the Swiss
Franc at fixed exchange rate with Euro. The Franc was pegged at 1.2 Swiss Franc per Euro for the
period 2011 to 2015. Once the de pegging was announced the franc value soared to 0.85 Swiss Franc
per Euro. Hedge Fund made big loses and the Swiss market collapsed.
The pegging of Swiss Franc to Euro was done in 2011 when there was market turmoil and crisis and
investors were considering Swiss Franc as safe heaven asset. As more and more people flocked
towards Swiss Franc, the currency became expensive and which hurt the Swiss export and services.
The Swiss market relied on export for 70% of GDP.
Body Of Solution
The Swiss National Bank undertook such decision based on following rationale:
(a) To make the currency popular: Since the currency was pegged, the currency was not popular
globally. Thus, in order to make currency popular and promote trading in currency de pegging
was executed; (Swiss National Bank,Zurich, 2019)
(b) Switzerland was an expensive place to do business: In order to promote trade and business in
Switzerland, de pegging was done as Switzerland was the most expensive place in Europe to do
business. Exporters and Service providers were having tough time in making profits under the
pegged currency as the value of Swiss Franc was low and the same soared once the de pegging
was done and the exporters made huge profits;
(c) Second reason that sails for de pegging the currency is the belief of Swiss National Bank that
Eurozone is not sustainable and the same shall sink in the long run. Accordingly, pegging the
currency against a weak currency shall destabilize the Swiss Economy in the long run;
(d) The third reason that sails through is the strong ambition of US economy of parity of Swiss
Franc with Euro whereby both the currency stand on the same footing and there is global
recognition of Swiss Franc as reserve currency or currency of trade. The ambition is in
alignment with its goals of recognition as super power in the world;
(e) The fourth reason is the external influence and pressure from wealthy individuals to soar the
currency as they find the currency weak in comparison to Euro. The wealthy individuals who
have invested or kept their money tied up in Swiss Bank felt that their investments shall not
provide them suitable returns on account of weak currency of Swiss Franc in comparison to
Euro;
Hedging Strategies implemented by Swiss exporter and other domestic firms
Since, Switzerland has major exports and its economy is high reliant on exports i.e. nearly 70% of
GDP of the economy constitute exports of goods. Accordingly, the firms had large foreign currency
risk exposure. This means that the business is open to risk in terms of adverse movement of currency.
Business dealing with overseas market is very much open to such currency and are popularly known
as Forex exposure. There are other kinds of exposure including commodity risk, Interest rate risk,
wage inflation etc. If the currency or the business is unhedged it can affect the balance sheet and
profitability of the company which can create cash issues (Oec, 2019). Hedging reduces such risk and
also helps in smooth functioning of the business. (Amadeo, 2019)
There are various strategies available in order to hedge which are here in below:

 Forward Contract: It is offered by banks currency forward contracts. It allows the business to
lock the future transaction with respect to sale and purchase of an item at an agreed price.
 Future Contracts: It is also similar to forward contracts. It is just the commitment to purchase
the currency at a future date at a pre-determined price listed.
 Currency Options: This is the option which is offered by the bank which provides an
opportunity to buy or sell the currency at a decided price on or before a define date.
Conclusion
The Swiss exporter and other domestic firms tried to implement the hedging strategy and wanted to
execute the same but it was not fulfilled ultimately the exporter has to bear the loss.

Question 2
Background
The second question seeks to analyse the cash flows under different hedging strategies that may
accrue to firm along with risk involved under each strategy. In the given case, the expected currency
exposure in Euro stands at 50 Million which shall be due at the end of the year. Further, the market
currency in which the payment is required is Dollar. The current exchange rate of Dollar against Euro
is 1.1 symbolising Euro is stronger against dollar. Further, the interest rate prevalent in the European
economy is 2% while on the other hand the rate prevalent in USA economy is 5%. Further, the
following data has been provided:
(a) 1 year forward rate stands at 1.13 symbolising 1 Euro can be exchanged for 1.13 dollar;
(b) Put option on Euro stands at strike price of 1.11 Dollar and the premium stands at 0.06;
(c) Call option on Euro stands at strike price of 1.15 Dollar and the premium stands at 0.08.
Based on above the probable cash flow under the following strategies has been computed:
(a) Unhedged Strategy;
(b) Forward hedged Strategy;
(c) Money Market Hedge;
(d) Option Hedge based on call and put.
Unhedged Strategy
The said strategy exposes the company to the risk of downfall of currency as there is no cover
undertaken but considering the interest rate prevailing in both economy and interest rate parity holds
good, unhedged strategy shall not carry much risk as the exchange rate is expected to rise in the short
term. The expected cash flow under the said strategy is given as under:
Strategy
1:
Unhedge
d
Strategy
Exposure 50 Mio Euro
Current Exchange Rate 1.1
Interest rate in USA 5.50%
Interest rate in Europe 2%
Estimated Future Exchange Rate 1.14
Expected Cash Flow 56.89 Mio Dollar
Thus, the expected cash flow under the said strategy is 56.89 Mio dollar assuming interest rate parity
holds good and the forward rate is 1.1*(1.055)/(1.02)
Forward Hedged Strategy
The said strategy is safe and sound and protects the company from any future fall in the exchange
rate, the said strategy provides the company with a fixed rate to trade and exposes the company to the
risk of missing out the gain of further increase in currency rate which may happen. Thus, the
exchange rate under the said cover is fixed. In addition, this is an over the counter derivative and
exposes the firm to risk of honour of contract or default.

Strategy
2:
Forwar
d
hedged
Strategy
Exposure 50 Mio Euro
Forward Rate 1.13
Expected Cash Flow 56.50 Mio Dollar
Thus, the expected cash flow under the said strategy is 56.50 Mio dollar
Money Market Hedge
Under the said strategy, we eliminate the risk of currency fluctuation by instantly converting the
exposure at present value to the currency of denomination and investing the proceeds in local
currency. The steps involved under the current scenario are:
(a) Discounting the exposure to present value;
(b) Converting the exposure to local currency using the prevalent exchange rate;
(c) Investing the local currency proceeds at the prevalent interest rate.
The computation of cash flow is presented as under:
Strateg
y 3:
Money
Market
Hedge
Step 1 Computing Present Value of 50 Mio Euro
Present Value 49.0196
1 Mio Euro
Step 2 Taking Loan from Bank of Same amount 49.0196
1 Mio Euro
Step 3 Converting it on the basis of current Exchange Rate 53.9215
7 Mio Dollar
Step 4 Investing the same in US Bank 53.9215
7 Mio Dollar
Step 5 Expected Cash flow at year end 56.8872
5 Mio Dollar
Thus, the expected cash flow under the said strategy is 56.88 Mio dollar
Option Hedge

This is the fourth strategy. Under the said strategy, the company may mitigate the risk of downside by
buying a put option or may expose the up side by selling the call option. Thus, under this options risk
is mitigated by buying premium. However, one sells the potential profit it may make if the
stock/currency move upward.
Strategy
4:
Option
Hedge
Put
Hedge
Exposure 50 Mio Euro
Put option on Euro (Strike Price) 1.11 Dollar 0.06
Cost from buying Put Option 3 Mio Dollar
Year End Rate 1.14
Cash Flow
53.8872
5 Mio Dollar
Call
Hedge
Exposure 50 Mio Euro 0
Call option on Euro (Strike Price) 1.15 Dollar 0.08
Income from selling call Option 4 Mio Dollar
Year End Rate 1.14
Cash Flow
60.8872
5 Mio Dollar
A brief summary of all the 4 strategies is presented as under:
Summary
Sly
No Particular Cash
Flow
1 Strategy 1: Unhedged Strategy 56.89
2 Strategy 2: Forward hedged Strategy 56.50
3 Strategy 3: Money Market Hedge 56.88725
4 Strategy 4: Option Hedge
Put Hedge 53.88725
Call Hedge 60.88725
The best strategy is Call Hedge assuming we sell call option as there is highest cash flow under the
said strategy.

References
Amadeo, K., 2019. Hedging and How It Works With Examples. [Online]
Available at: https://www.thebalance.com/hedge-what-it-is-how-it-works-with-examples-3305933
[Accessed 30 March 2020].
Oec, 2019. Switzerland. [Online]
Available at: https://oec.world/en/profile/country/che/
[Accessed 30 March 2020].
Swiss National Bank,Zurich, 2019. Monetary policy by year. [Online]
Available at: https://www.snb.ch/en/iabout/monpol/id/monpol_current
[Accessed 30 March 2020].