Question

Assume your company has a contract to purchase 100 computers from a Korean company. The payment is due on receipt of the shipment and must be delivered in Korea on 1 December 2018. On 1 July 2018, when you are arranging the contract, the computers are priced at 500,000 won each. On 1 July 2018, the spot exchange rate is AU$1 in exchange for 1,250 won (KRW). Assume that the 6-month interest rate in Korea is 3% and the rate in Australia is 5%. Assume that the covered interest parity holds.

(A) Calculate the Australian dollar price (on 1 July 2018) of one unit of Korean currency (rounding to 4 decimal places).

(B) What is the total price of the computers in Australian dollars on 1 July 2018 (rounding to 2 decimal places)?

(C) Calculate the 6-month forward exchange rate, FKRW/$, under the covered interest parity (rounding to 2 decimal places). Note that the forward rate is defined as the Korean won per AU$1.

(D) What would you advise your firm to do to avoid a loss on the deal if the Korean won costs 5% more compared to the Australian dollar (the expected depreciation rate of Australian dollar against Korean won is 5%) when payment is due on 1 December 2018? The answer should have the exact numbers (rounding up to 2 decimal places) that you would tell your CEO.

Hint: You want to get rid of the exchange rate risks.

Answer 1

(a) Exchange Rate on 1st July 2018: 1250 KWR / 1 AU $

Price of One Unit of Korean Currency = 1 / 1250 = 0.0008 AUR $

(b) Price per Computer = 500000 KWR, Number of Computers Bought = 100

Therefore, Total Price of Computers in AU $ = (500000 x 100) / 1250 = 40000 AU $

(c) 6-month Interest Rate in Korea = 3 % and 6-month Interest Rate in Australia = 5 %

Current Spot Rate = 1250 KWR / AU $

Therefore, 6-month Forward Rate = 1250 x [1.03/1.05] = 1226.19 KWR / AU $

(d) If the Korean Won is expected to appreciate against the AU $ in 6-months time, it would make sene to hedge against the exchange rate risk by means of a suitable derivative such as a forward contract on KWR, Call Option on KWR, Put Option on AU $ and othe money market instruments.