Treasury & Risk Management Assignment

Treasury & Risk
Management
STUDENT ID:
[Pick the date]

Question 1
The central bank plays a pivotal role in the currency exchange rate determination. This may
be through direct or indirect intervention. The central bank controls the supply of the
domestic currency through printing. Additionally, it may intervene in the currency markets by
buying or selling either the domestic currency or the foreign currency in order to ensure that
there are no drastic fluctuations in the exchange rate. A stable currency exchange rate is
pivotal for functioning of a healthy economy which is particularly true for a country which is
significantly dependent on international trade. A case in point is Switzerland which generates
about 70% of the GDP through goods and services exports. As a result, the Swiss National
Bank SNB) ought to play a critical role in ensuring the stability of the Swiss Franc. This is
apparent from the exchange rate peg that the bank introduced in 2011 when the financial
markets were in turmoil and there was appreciation of Swiss Franc. As a result of this pegged
current, the Swiss Franc was maintained at a fixed value of €1.2. Considering the pegging to
the Euro along with the fiscal prudence by the Swiss government, the Swiss Franc started to
be considered as a safe haven in the aftermath of introduction of pegging (Economist, 2015).
As a result of this, there was huge flow of money into Switzerland which increased the
demand for Swiss Francs and hence exerted pressure of appreciation on the Swiss Franc. In
order to maintain the currency level at the designated peg, new francs were printed by SNB
and this money was used to buy euros. The net result was that by 2015, the SNB had amassed
foreign currency reserves to the extent of $ 480 billion which was estimated to be about 70%
of the GDP. With regards to these huge foreign reserves, there was considerable anger
amongst the people which is one of the main reasons for the sudden de-pegging of Swiss
Franc. The public anger can be gauged from the fact that some months earlier to de-pegging
of the currency, there was a referendum which could have limited the ability of the SNB to
increase foreign reserves (Economist, 2015). There was also fear of hyperinflation on account
of too much money being printed. Additionally, the SNB decision came at a time when ECB
(European Central Bank) was on the verge of introducing quantitative easing to buy debt
which would have led to devaluation of euro and hence would have required the SNB to
purchase even more francs to maintain the peg (Blackstone, 2015).
Considering the unsustainability of the currency peg, the SNB in a swift decision decided to
de-peg the currency. This had a tremendous impact on the value of the Swiss Franc which
soared from 1.2 euro to about 0.85 euro in a single day. As a result, there was a cut in the

economic growth estimate of Switzerland which is expected considering the country’s
excessive reliance on exports (Klein, 2017). The exporters were the worst hit due to this
decision. However, this decision highlighted the need for hedging in wake of increased
currency risk. The hedges deployed by Swiss company can be categorised into two sub-
categories namely natural hedge and financial hedge. Considering the strong Franc, it is
always advantageous for the exporting firms to source various raw materials from outside
Switzerland and pay the suppliers in USD since America is one of the main export
destinations of exporters in Switzerland. This not only lowers the overall cost but also works
as a natural hedge. Besides, financial hedges include foreign currency swaps, derivatives
along with forward agreements. These have been quite effective as various research studies
have indicated that future contracts based in Swiss Francs are highly effective to ward off the
underlying currency risk (Choi, 2009). This is not surprising considering the heavy reliance
on exports in the Swiss economy coupled with the strong inflows in the country which is
always putting an appreciative pressure on the currency. In such an environment, the
exporters need to take various measures to hedge their exports in order to maintain their
underlying competitiveness in the market place (Klein, 2017).
From the above discussion, it is apparent that the main reason behind the de-pegging of Swiss
Franc by the SNB was the unsustainable pumping in of Francs in order to support a weak
euro which led to excessive printing of Swiss Francs coupled with high euro based foreign
currency reserve. The de-pegging of currency proved disastrous for the exporters since the
Swiss Franc appreciated significantly. As a result, various hedging strategies have been
successfully put in place by the exporters and importers in order to minimise the currency
risk through the use of natural and financial hedges. The hedging strategy used has been quite
effective as highlighted in the various research studies.
Question 2
a) (i) Unhedged Strategy
In an unhedged strategy, the exporter would bear all the exchange rate risk owing to the
current fluctuation. If there is appreciation in the USD with regards to Euro, then the net cash
inflow for the exporter would reduce which would adversely impact the profit.