Question

a2 Milk Ltd Pty.

a2 Milk is an Australian company specialising in producing fresh milk and milk formula. The company has its operations in Australia. Therefore, there expenses are generally invoiced in Australian dollars (AUD). However, it has recently imported supplies from New Zealand, and the bill is invoiced in the New Zealand dollars (NZD) for NZD 1,500,000, payable in 6 months’ time.

Suppose a2 Milk’s management is concerned about foreign exchange rate exposure, and would like to hedge this risk. Suppose also that you observe the following quotes in the foreign exchange market:

Currency		In USD	Per USD
AUD	Spot	0.7289	1.3719
	1-month forward	0.7280	1.3736
	3-month forward	0.7264	1.3767
	6-month forward	0.7242	1.3808
NZD	Spot	0.6759	1.4795
	1-month forward	0.6763	1.4786
	3-month forward	0.6785	1.4738
	6-month forward	0.6800	1.4706

The banker offers to set up a forward hedge based on the NZD/AUD forward cross-exchange rate implicit in the forward rates against the dollar. Suppose you are a risk manager at a2 Milk. You are required to advise the CEO the following:

1. The AUD equivalent of this transaction at the current spot exchange rates. (Could explain in details and step by step)

Answer 1

a2 Milk needs to pay 1,500,000 NZD after 6 months

So in the forward hedge , one needs to find the NZD/AUD rate i.e. the no of AUD equivalent to 1 NZD

NZD/AUD = NZD/USD * USD/AUD

At the current spot rates ,

NZD/AUD cross rate =    0.6759*1.3719 = 0.9273

So, 1 NZD = 0.9273 AUD at the spot rate

So, the AUD equivalent of the payable of NZD 1,500,000 = 1,500,000* 0.9273 = AUD 1,390,950   at the current spot exchange rates

The Forward rate which can be entered into using the cross rates is

NZD/AUD 6 month cross rate = NZD/USD 6 month forward rate * USD/AUD 6 month forward rate

= 0.6800*1.3808

= 0.9390

So, using the forward hedge, the AUD equivalent of the payable of NZD 1,500,000 will be 1,500,000* 0.9390 = AUD 1,408,500