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S3662739 - Cobey Smith

Final Assignment

Exposure the XYZ firm would endure fall under three categories: Transaction Exposure Transaction exposure is the risk of fluctuation in the currency rate between the time when a deal occurred between the importer and the exporter, till the time it was actually settled. In this instance, for the RBA to lower the cash rate will cause volatility in the exchange rate. This would cause uncertainty about the future value of exchange rates and is a potential risk to the XYZ firm. Operating Exposure Operating exposure is the risk of fluctuation in the currency rate that can impact future cash flows and the firm’s value. This exposure is from foreign markets not performing as well as the domestic market. This in turn means less imports, this also would decrease foreign reserves, which would make the $AUD currency rate go weaker. The more we sell a foreign currency to buy domestic currency, the more upward pressure is built on the domestic currency rate ($AUD). Translation Exposure Translation exposure is the risk of fluctuation in the currency rate that will change the value of a firm's equities, assets, liabilities or income. Issuing a 500,000 USD bond will mean raising money in USD, while simultaneously borrowing from USD. If the XYZ firm has to make payments in USD, then they can be made directly without the need to convert them into Euros. This means the firm will be selling the USD to purchase EUR, hence an upward pressure on the Euros.

Available Hedging Strategies in the market include: 1. Forward Hedging 2. Futures Hedging 3. Options Receivables 4. Money Market Hedge

Forward Hedging U.S importer owes the firm XYZ USD 300,000 which are due in 4 months, therefore we will do forward hedging of receivables:

K = USD 300,000 S0 = 0.71 >> 1/0.71 = 1.40 (USD/AUD) F0 = 1.35 >> = 1/1.35 = 0.74 S1 (NAB’s Forecast) = 1/0.74 = 1.351 No Hedge profit/loss = 300,000 x (1.351 - 1.40) Hedge profit/loss= 300,000 x (0.74 - 1.351) Net position = K (F0 – S0) = K (S1 – S0) + K (F0 - S1) = -14700 + (-183300) = -198000

XYZ owes a payment of EUR 400,000 to a foreign supplier in 3 months: K = EUR 400,000 S0 = 0.60 >> 1/0.60 = 1.66 (EUR/AUD) F0 = 1.6 >> = 0.625 S1 (NAB’s Forecast) = 1/0.61 = 1.639 No hedge Profit/Loss = 400,000 x (1.66 – 1.639) Hedge profit/loss =400,000 x (1.639 - 0.625) K(S0 – F0) = K(S0 - S1) + K(S1 – F0) Net position = 8400 + 405600 = 414,000

Options Hedging Receivables Hedged = USD 300,000 x (1.40 - 0.08) x 0.4 + 300,000 X (1.351 - 0.08) x 0.6 = 387180 Unhedged = USD 300,000 x 1.351 x 0.4 +300,000 x 1.639 x 0.6 = 457140 Since the expected value of the receivables is over the hedge decision is lower than otherwise, a hedge would not be taken.

Money Market Hedge Payables Australian Firm owed EUR 400,000 in 3 months Step 1: Invest present value of EUR 400,000 at 0% interest for 3 months Step 2: Buy Spot EUR 400,000 at 0.71 at 0.71 AUD/EUR Requires AUD = 400,000 x 0.71 = AUD 284,000 Step 3: Borrow AUD 284,000 at 0.25% for 3 months Outflow after 3 months = 284,000 x 1.000625 = AUD 284,177.50 Outflow under money market hedge =AUD 284,177.50

As for recommendations, you should use Forward Hedging as it displays a small profit of 14,000

Source of Data include Yahoo finance, Trading Economics and NAB (Viewed 23/10/20) Spot Rates https://finance.yahoo.com/quote/AUDUSD=X/ https://au.finance.yahoo.com/quote/AUDEUR=X?p=AUDEUR=X Interest Rates https://tradingeconomics.com/australia/interest-rate#:~:text=Interest%20Rate%20in%20Australi a%20averaged,percent%20in%20March%20of%202020. https://tradingeconomics.com/euro-area/interest-rate https://tradingeconomics.com/united-states/interest-rate Forecasted Spot Rates https://www.nab.com.au/business/international-and-foreign-exchange/financial-markets/exchan ge-rate-forecast

Appendix Currency Pair

Price of Call

Price of Put

Exercise Put

Exercise Call

Fwd Rate

S(AUD/EUR)

0.007

0.01

0.62

0.45

1.6

S(AUD/USD)

0.006

0.008

0.73

0.61

1.35

Spot Rates (Yahoo Finance)

Spot Rate

Interest

AUD = 0.25 0.6 EUR = 0.00 0.71

AUD =0.25 US = 0.09

Interest Rates (Trading Economics)

Forecasted Spot Rates (NAB)...