Question

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 wine in Australia can be shipped to the United States immediately but you have three months to conduct payment.

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 Britain. The payment of £2,500,000 for the export to Britain 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)
$/£	1.30009	1.30611	1.31217	1.31825	1.32436
$/AUD	0.72390	0.72516	0.72641	0.72766	0.72892

Bank applies 360 day-count conventions 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%
Britain	0.786%	0.747%	0.794%	0.755%	0.801%	0.762%	0.809%	0.770%
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 actually 2.687%/4 = 0.67175% (always round to 7 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 $
$/£	$1.29961	$0.00383	$1.31268	$0.00383	$1.30564	$0.00381	$1.31876	$0.00381
$/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 month $ option premium is subject to 2.687%/4 interest rate.)

c. 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).

Table 5: Australia: Exchange rate hedges compared:

	Forward rate	Money market hedge locked in exchange rate	Option hedge breakeven exchange rate
$/AUD

Which hedging technique should be applied? ____________________________________

Answer 1

c) For the Australian Import transaction where AUD 2.5 million is payable in 3 months

If the forward hedge is used, the US company can fix a rate of USD 0.72516/ AUD for the transaction (3 month forward rate)

For the money market hedge, US importer has to borrow USD , convert them to AUD and invest in Australia so that after 3 months , he gets AUD2.5 million

Going backwards, to get AUD 2.5 million after 3 months , amount in AUD required to be invested today

= AUD2.5 million/ (1+0.01875/4) = AUD 2488335.93

The equivalent amount in USD which will be borrowed = AUD 2488335.93* 0.72390 $/AUD = USD 1,801,306.38

So, the final amount payable in USD = 1801306.38* (1+0.02687/4) = USD 1813406.66

So, the exchange rate fixed by money market hedge = USD1813406.66/AUD 2500000 = 0.725362 or USD 0.72536/AUD

For options hedge, the US  Importer has to buy the AUD after 3 months, so 3 month call option is required , premium = $0.0069/ AUD

Total premium to be paid today (by borrowing)=USD 0.0069/AUD* AUD2,500,000 = USD 17250

Amount to be repaid after 3 months = USD 17250* (1+0.02687/4) = USD 17365.88

By options hedge, the maximum USD amount to be paid is fixed = 0.72155* 2500000 = USD 1803875

So, maximum amount to be paid after 3 months in USD = 17365.88+ 1803875 = USD 1821240.88

So, the maximum exchange rate (breakeven exchange rate) fixed by options hedge = USD1821240.88/AUD 2500000 = 0.7284963 or USD 0.72850/AUD

For pure hedging, the US importer should apply Forward hedge as the USD per AUD required to be paid is the least.

However, options hedge may prove beneficial in case of high volatility in exchange rates.