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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US firm has a Swiss subsidiary with net assets of CHF 20 million. The CHF/USD rate (USD per CHF) falls from 1.10 to 1.05 over the year. Under a balance-sheet hedge the parent wants to eliminate translation exposure on net assets. What is the translation loss on the unhedged net assets, and what hedge action offsets it?

The unhedged loss is USD 1.0 million, which is CHF 20 million times the 0.05 fall in the rate. A balance-sheet hedge offsets it by matching CHF liabilities, such as CHF borrowing, to CHF assets, bringing net exposed assets to zero.

  1. AUSD 1.0 million loss; reduce CHF net assets exposed, for example by borrowing CHF 20 million to offsetCorrect
  2. BUSD 1.0 million gain; increase CHF net assets by lending CHF
  3. CUSD 1.0 million loss; sell USD forward
  4. DUSD 0.5 million loss; borrow CHF 10 million

Explanation

Loss = 20 million x (1.10 - 1.05) = USD 1.0 million. A balance-sheet hedge sets exposed CHF assets equal to CHF liabilities, such as by financing the subsidiary with CHF borrowing so net exposure is zero. Selling USD forward would increase, not reduce, the exposure to CHF depreciation.

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