Swiss National Bank Currency Interventions †MyAssignmenthelp.com

Question: Discuss about the Swiss National Bank Currency Interventions. Answer: Introduction: 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 resul t 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 countrys 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. Beside s, 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. 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. Based on the available data, there is a high probability of appreciation in USD. This is apparent from the higher interest rate in USA as compared to Europe owing to which there would be higher foreign money inflow into US leading to increased demand for USD potentially causing an appreciation of USD against Euro. This scenario is also reflected in the forward exchange rate. Therefore un-hedged strategy would result in 100% exposure to exchange rate risk with the exporter (Northington, 2011). In this strategy, hedging is achieved through buying or selling of forward contracts. Since the exporter would receive Euro, hence it would be advisable that a 1 year forward contract is sold to a bank. This implies that 1 year from now, the bank would provide an agreed amount of euros based on the forward exchange rate (Petty et. al., 2015). For instance, the 1 year forward contract rate is $1.13 per Euro, hence irrespective of the exchange rate prevalent at the time of settlement, euro would be converted into USD at the above rate. Hence, for 50 million euros, the amount received would be 50000000/1.13 = USD 44,247,788. IF the exchange rate is above $ 1.13 per Euro (like $ 1.14), then the exporter would benefit from the hedge while if the exchange rate is lower than $ 1.13 per Euro, then the exporter would lose. A key risk of this strategy is that the hedge cannot be bought over the whole amount considering that the amount of Euros to be received by vary by 10 million. However, by covering 40 million, a significant portion of the exchange rate can be hedged. Also, another risk relates to counterparty risk which happens when the other party does not uphold the promise (Brealey, Myers and Allen, 2012). In this hedging strategy, money to the extent of expected receivables would be borrowed in Euro by the US based exported and converted into USD at the spot rate and invested in US. Assume expected cashflows after one year be 50 million Also, annual interest rate in euro zone = 2 % pa Hence, required borrowing = 50000000/1.02 = 49,019,608 After one year, the above borrowing would amount to 50 million euros and hence the received payment from the importer would be deviated to settle this debt. The borrowed amount in euros would be converted to USD based on the current spot rate of $ 1.10 per euro. Hence, amount in USD = 49,019,608/1.1 = $44,563,280 The above money would be invested in US at 5.5% p.a. Thus, after one year the exported would receive = 44,563,280*1.055 = USD 47,014,260 A problem area with this strategy is the uncertainty with the amount received after one year and hence only partial hedging can be performed and thereby some exposure to current risk would still remain. A key risk is that the interest rate may change and hence the amount in USD may fluctuate (Parrino and Kidwell, 2011). Since US exporter would receive money, hence for hedging currency risk, the put option needs to be bought. In the given case, the exercise price is $ 1.11 with a premium of $ 0.06 per unit. In the option hedging strategy a large amount of flexibility is available at the cost of a small premium. The payoff of this strategy on a per unit basis can be explored as follows. It is apparent that the worst case exchange rate is capped at $1.17 per euro but there is a potential upside on the future especially if there is significant depreciation of the USD against the Euro. A key risk of the strategy relates to the number of contracts that need to be bought considering that the final amount cannot be determined as of now and hence complete hedging becomes difficult (Petty et. al., 2015). The best option would be money market hedge as has been demonstrated with 50 million euros example where the final amount to the exporter in USD is more as compared to a forward contract hedge. Also, option hedge would be useful only when there is significant depreciation of USD against the Euro which may or may not happen. Thus, the risks are minimised for the exporter using a money market hedge assuming an expected receivable of 50 million after a year (Northington, 2011). References Blackstone, B. (2015) What Happened with the Swiss Franc, [online] Available at https://blogs.wsj.com/briefly/2015/01/15/what-happened-with-the-swiss-franc-the-short-answer/ [Assessed March 22, 2018] Brealey, R.A., Myers, S.C. and Allen, F. (2012)Principles of corporate finance. 2nd ed. New York: McGraw-Hill Inc Choi, M. S. (2009). Currency risks hedging for major and minor currencies: constant hedging versus speculative hedging. Applied Economics Letters, 17(3), 305-311. Economist (2015) Why the Swiss unpegged the franc, [online] Available at https://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13 [Assessed March 22, 2018] Klein, M. (2017) Have the Swiss National Banks currency interventions actually been good for Switzerland?, [online] Available at https://ftalphaville.ft.com/2017/06/02/2189554/have-the-swiss-national-banks-currency-interventions-actually-been-good-for-switzerland/ [Assessed March 22, 2018] Northington, S. (2011) Finance, 4th ed. 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