International Finance Case Study Exchange Rate Hedging Questions

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INSTRUCTIONS: READ THE QUESTIONS CAREFULLY.  ANSWER THE QUESTIONS ON THE SEPARATE ANSWER SHEET THAT CAN BE DOWNLOADED

You are the manager of a U.S. company situated in Los Angeles and manages the import/export division of the company. The company distributes (resells) a variety of consumer products imported to the U.S.A from Australia and also exports goods manufactured in the U.S.A. to Canada.

Therefore, your company is very much dependent on the impact of current and future exchange rates on the performance of the company.

Scenario 1:

You have to estimate the expected exchange rates one year from now between your home currency and the other currencies of the major other countries that you deal with in terms of both imports and exports.  The reason is that increases in the values of other currencies compared to the U.S. Dollar may impact your imports negatively, whilst it may on the other hand, be good for exports. To do this estimate, you obtain the following spot exchange rate information:

CAD$/$ 1.30779
AUD$/$ 1.38140

You also obtain the following rates that you regard as similar to the annual risk-free rates applying in the countries:

U.S.A. 2.660%
Canada 2.155%
Australia 1.953%

Your focus is presently to estimate the 12-month forward rates in order to consider the impact that it will have on the import and export sales of the company. Calculate the forward rates of the $ in terms of all the currencies by using simple interest rate parity e.g., 10% annual interest rate = 10/2 = 5% for six months.  Do not effective annual interest rate compounding. Show all your workings in Table 1 on the separate answer sheet by using the correct formula provided in your formula sheet.

Provide an indication about what will happen to the value of the US$ based on the forward exchange rate calculations by calculating the expected discount/premium of it for each of the currencies in Table 2 on the separate answer sheet. Also show whether the impact will be positive (P) or negative (N) for imports and exports. For example:

Exchange rate % Discount/Premium Import Export
 £/$ Workings by you …………….= 1.93% premium Positive Negative

Scenario 2:

Considering the calculations that you have done so far; you need to attend to several import and export transactions for goods that companies in the United States expressed interest in.

The first transaction is for the import of good quality wines from Australia, since a retail liquor trading chain customer in the United States, for who you have been doing imports over the past five years has a very large order this time. The producer in Australia informed you that the current cost of the wine that you want to import is AUD$2,500,000. The producer in Australia will only ship goods in three months’ time due to seasonal differences but payment will have to be conducted six months from now.

The second transaction is for the export of 3d printers manufactured in the U.S.A. The country where it will be exported to is Canada. The payment of CAD 2,500,000 for the export to Canada will be received nine months from now.

You consider different transaction hedges, namely forwards, options and money market hedges.

You are provided with the following quotes from your bank, which is an international bank with branches in all the countries:

Forward rates:

Currencies Spot 3 month (90 days) 6 month (180 days) 9 month (270 days) 12 month (360 days)
$/CAD 0.76465 0.76559 0.77475 0.76748 0.76843
$/AUD 0.72390 0.72516 0.72641 0.72766 0.72892

Bank applies 360 day-count convention to all currencies (for this assignment apply 360 days in all calculations).

Annual borrowing and investment rates for your company:

Country 3-month rates 6 months rates 9-month rates 12-month rates
Borrow Invest Borrow Invest Borrow Invest Borrow Invest
United States 2.687% 2.554% 2.713% 2.580% 2.740% 2.607% 2.766% 2.633%
Canada 2.177% 2.069% 2.198% 2.090% 2.220% 2.112% 2.241% 2.133%
Australia 1.973% 1.875% 1.992% 1.894% 2.012% 1.914% 2.031% 1.933%

Bank applies 360 day-count convention to all currencies. Explanation – e.g., 3 month borrowing rate on $ = 2.687%. This is the annual borrowing rate for 3 months. If you only borrow for 3 months, the interest rate is 2.687%/4 = 0.67175% (always round to 5 decimals when you do calculations). Furthermore, note that these are the rates at which your company borrows and invests. The rates are not borrowing and investment rates from a bank perspective.

Option prices:

Currencies 3-month options 6-month options
Call option Put option Call option Put option
Strike Premium in $ Strike Premium in $ Strike Premium in $ Strike Premium in $
$/CAD $0.76292 $0.00392 $0.76828 $0.00392 $0.77205 $0.00387 $0.77747 $0.00387
$/AUD $0.72155 $0.00690 $0.72843 $0.00690 $0.72279 $0.00688 $0.72969 $0.00688

Bank applies 360 day-count convention to all currencies. (Students also have to apply 360 days in all calculations). Option premium calculations should include time value calculations based on US $ annual borrowing interest rates for applicable time periods e.g., 3 months $ option premium is subject to 2.687%/4 interest rate.)

  1. Calculate the cost of money market hedges for the imports from Australia (Complete Table 3 on the separate answer sheet)
  2. Determine the option types that you will consider based on the exchange rate quotes provided by your bank. Remember we will long or short the base currencies (in this case study the currencies that are not $) and the FV of premium cost is based on the borrowing cost of $ for the period of the option. For example, if it is a 3-month option, then the interest rate that should be applied is United States 3 month borrowing rate of 2.687%/4 = 0.67175%). Calculate the total cost of using options as hedging instrument for the import from Australia (Complete Table 4 on the separate answer sheet)
  3. Compare the forward quotes, money market hedges and options with each other to determine the best exchange rate hedges for Australia (Complete Table 5 on the separate answer sheet)
  4. Calculate the exchange rates that will apply if the money market hedges are used for the exports to Canada (Complete Table 6 on the separate answer sheet)
  5. Compare the forward quotes and money market hedges with each other to determine the best exchange rate hedges for Canada (Complete Table 7 on the separate answer sheet)
  6. Assume you entered the forward hedge for the import from Australia. Four months have passed since you entered the hedge. Interest rates are the same as before. The spot exchange rate of the $/AUD is 0.72551. Calculate the value of your forward position. Please use a 360 day-count convention, since the bank also used a 360 day-count convention with the forward quotes provided to you. Also remember for interest rates use risk free rates provided under scenario 1. Show your calculation in Table 8 on the separate answer sheet.

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