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 explain step by step:

1. Whether the company should hedge. If so, show the CEO how you would hedge this risk exposure with the available forward contracts. (Could you explain in details and step by step)

Answer 1

Yes, we should hedge otherwise we will be exposed to currency exchange rate risk.

As we expect a payment of NZD 1,500,000 we should enter into 6month forward contract.to exchange NZD to USD and then USD to AUS

After 6 months exchange NZD 1,500,000 to get 0.68*1,500,000 USD.

You will get 1,020,000 USD

Now exhcnage this 1,020,000 USD to get 1.3808 * 1,020,000 AUS.

You will get 1,408,416 AUS

There is no currency risk in this. Whatever be the spot rate you will get 1,408,416 AUS.