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

A US firm's Canadian subsidiary has net assets of CAD 50 million. The spot rate is 1.3000 CAD per USD. The firm hedges translation exposure with a forward sale of CAD 50 million at 1.3000 for one year. At maturity spot is 1.4300 CAD per USD. Ignoring interest differentials, what is the net effect on USD of the hedge and translation combined?

The net effect is approximately zero. Translation of CAD 50 million falls from USD 38.46 million to USD 34.97 million, a loss of about USD 3.5 million, while the forward sale of CAD at 1.30 gains the same amount. The hedge offsets the translation loss.

  1. AZero; the forward gain of about USD 3.5 million offsets the translation lossCorrect
  2. BA net loss of about USD 3.5 million
  3. CA net gain of about USD 3.5 million
  4. DA net loss of about USD 7.0 million

Explanation

Net assets: 50/1.3 = USD 38.46m, then 50/1.43 = USD 34.97m, a translation loss of 3.50m. Forward sells CAD at 1.30 receiving USD 38.46m, and buying back CAD at 1.43 costs 34.97m, a gain of 3.50m. The two offset, leaving zero net.

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