Hedging PDF

Preview

Summary

Running head: MORALES 1 Hedging Foreign Currency Risks Michael Morales SNHU MORALES 2 Current State The Eurozone is a geographic and economic region the consists of all the EU countries and uses the euro as their form of currency. (Staff, 2005) The economy is not immune to exchange rate fluctuations...

Description

Running head: MORALES

1

Hedging Foreign Currency Risks Michael Morales SNHU

MORALES

2

Current State The Eurozone is a geographic and economic region the consists of all the EU countries and uses the euro as their form of currency. (Staff, 2005) The economy is not immune to exchange rate fluctuations nor the devaluation of other currencies. The current state of the Eurozone is poor. According to Wallace Fan, the European Central Bank further reduced its benchmark interest rate by 10 basis points to a fresh record low of 0.05 per cent, and announced an as set-backed securities purchase program in the hope of unblocking lending and fighting deflation in the Eurozone. (Fan, 2017) There are several factors that are attributing to the slow recovery of the Eurozone’s economy. These factors include Italy’s economic revival, German economic powerhouse contracted, the stall of the French economy, a five-year low on the inflation rate. The euro fell to US $1.3119 in Asia in 2014 and hit a five-week low against the British pound of 78.92 pence. The Swiss franc cap is a potential threat the Eurozone. This cap was introduced by the Swiss National Bank to maintain export competition and aid in economic growth. The Australian Dollar (AUD) carries its own political and volatility risks associated with the euro. The AUD has had a long period of high valuation against other major currencies. (Fan, 2017) The AUD was traded with the US at a high of 1.05, however volatility caused it to decrease to below 0.90. Volatility has caused fluctuations in trading between the AUD and the USD. This brings up the topic of trade between the AUD and the euro (EUR). According to Fan, the pair was at around 0.80 for most of 2012 and 2013, but dropped to 0.70 on 2013. (Fan, 2017) It has been argued that the AUD was fluctuation due to a deep correction with upcoming changes that include falling iron ore prices, weak consumer sentiment, and sub-par economic growth. Due to fluctuations between the AUD and USD and a slow growth rate, F. Mayer imports would need to reevaluate their stand of imports as compared to AUD and EUR.

MORALES

3

Efficacy The efficacy of F. Mayer’s current hedging practice benefited the company while the AUD environment was strong. Lower import costs allowed for a competitive advantage for the company and allowed for new client relationships while solidifying current relationships. The question then becomes what if the AUD/EUR did not rebound or ended up rebounding. Either of these scenarios has a negative affect on the company. This is where the possibility of vanilla foreign exchange forward contracts would come in. Depending on the entities included within the contract, if the rebound did not occur, F. Mayer could collect the initial investment at the locked in rate when the contract expires. If the market rebounds, F. Mayer could let the contract expire and collect the investment at the higher rate. There is also an opportunity for F. Mayer to wait for a higher rebound rate and hedge a forward exchange contract for one – to – three months. There is no sure thing when it comes to the economy. Further data would need to be collected to make an educated and informed decision. Procurement F. Mayer should leave their euro procurement unhedged. Granted the risk to the company is great and fluctuations with regards to exchange rates, there is a competitive advantage for the company. As stated earlier, the is no sure thing with any economy. A press release, released by Glenn Stevens, cited many positive aspects to growth within the global economy. In Australia, the most recent survey data indicate gradually improving business conditions and some recovery in household sentiment after a weaker period around midyear, suggesting moderate growth in the economy is occurring. (Fan, 2017) This signals a positive aspect for F. Mayer. The AUD/EUR exchange rate will either remain at its current level, allowing F. Mayer to keep their competitive advantage or it will increase, allowing F. Mayer to restructure their competitive plan while

MORALES

4

making a profit. By hedging their euro procurement, F. Mayer may have greater risks associated with pricing and customer relationships. Granted hedging may positively affect the bottom line, the loss of relationships would adversely affect the bottom line. Hedging Strategies There are three strategies presented for hedging F. Mayer Imports. The first strategy allows F. Mayer the right (no obligation) to buy EUR and sell AUD at the strike rate of on the expiry date. On the expiry date, if the prevailing spot AUD/EUR is below the strike rate, then the company will exercise the right to deal at the higher strike rate. If the prevailing spot AUD/EUR rate is higher than the strike rate, then the company will let the option lapse and buy EUR against the AUD in the spot market at the higher rate. The second strategy locks F. Mayer into a range where they have a worst-case rate and the capacity to participate in favorable AUD/EUR movements up to the sold call strike. The worst-case rate would be the budgeted rate. A collar structure is used for this strategy and uses the FEC rate, which is the rate used as opposed to the sot rate. The third strategy secures the worst-case rate at 0.6890. At the beginning of the option, F. Mayer buys an AUD put option with a strike of 0.6890. If 0.7140 trades at any time between the option start and expiry date, then you are “knocked in” to a sold AUD call option with a strike of 0.6890. (Fan, 2017). Each strategy has a term of four (4) months. Of the three strategies presented, the strategy the F. Mayer should use the second strategy to protect its investment. A range of values are given to illustrate best- and worst- case scenarios and the risks associated with them. The overall risks could be minimized in the long run with the proper planning and budgeting.

MORALES

References Fan, W. (2017). F. Mayer Imports: Hedging Foreign Currency Risk. Harvard Business Review , 1-8. doi:W17113 Staff, I. (2005, November 13). Eurozone. Retrieved December 14, 2017, from https://www.investopedia.com/terms/e/eurozone.asp

5...