A US-Based Corporation Has Decided to Make an Investment in Norwegian

question 14

Multiple Choice

A US-based corporation has decided to make an investment in Norwegian Kroner of NOK 500 Million (NOK = Norwegian Kroner) in 3 months. The company wishes to hedge changes in the the US dollar-NOK exchange rate using forward contracts on either the euro (EUR) or the Swiss Franc (CHF) . The company makes the following estimates:
-If EUR forwards are used: The standard deviation of quarterly changes in the USD/NOK spot exchange rate is 0.005, the standard deviation of quarterly changes in the USD/EUR forward rate is 0.025, and the correlation between the changes is 0.90.
-If CHF forwards are used: The standard deviation of quarterly changes in the USD/NOK spot exchange rate is 0.005, the standard deviation of quarterly changes in the USD/CHF forward rate is 0.020, and the correlation between the changes is 0.80.
The current USD/NOK spot rate is 0.160 (i.e., USD 0.160 per NOK) , the current 3-month USD/EUR forward rate is 1.36, and the current 3-month USD/CHF forward rate is 1.04.
If the company wishes to carry out a minimum-variance hedge, which currency should it use for this purpose?

• A) CHF, because the forward exchange rate of near 1 makes it "more" like the USD.
• B) EUR, because Norwegian trade with the eurozone countries far exceeds its trade with Switzerland.
• C) EUR, because of the higher correlation of 0.90.
• D) CHF, because of the lower correlation of 0.80.

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