You are the vice president of finance for exploratory resources, headquartered in Houston, Texas. In January 20X1, your firm’s Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. \(0.8995/ Canadian dollars and the Canadian currency was selling at a discount in the forward market. The June 20X1 contract (face value = C\)150,000 per contract) was quoted at U.S. $0.8930/ Canadian dollar.

a. Explain how the Houston bank could lose on this transaction assuming no hedging.

b. If the bank does hedge with the forward contract, what is the maximum amount it can lose?

Step by step solution

01

Spot Market

When exchange rate was U.S. $0.8995/ Canadian dollar, the original loan value equals

$\begin{array}{c}Loan\text{value}=Canadiandollar\text{value}\times U.S\text{dollar}perCanadiandollar\\ =150,000\times \$0.8995\\ =\$134,925\end{array}$

02

Forward market

When exchange rate was U.S. $0.8930/ Canadian dollar, the repayment value of loan equals

$\begin{array}{c}Repayment\text{value}=Canadiandollar\text{value}\times U.S\text{dollar}perCanadiandollar\\ =150,000\times \$0.8930\\ =\$133,950\end{array}$

Hence, buying value is greater than the selling value. It is a loss.

03

Calculation of loss

$\begin{array}{c}Loss=Loanvalue-\text{Repayment}value\\ =\$134,925-\$133,950\\ =\$975\end{array}$

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