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A mining company in Australia has entered into a contract to export iron ore into China...

A mining company in Australia has entered into a contract to export iron ore into China with delivery in three months’ time. The contract is denominated in Chinese Yuan, CNY and is valued at CNY 500 million. The current spot exchange rate is AUD/CNY 5.18. Assume that the expected spot rate in three months’ time is AUD/CNY 5.13. The three-month futures contract for Australiandollar and Chinese Yuan is trading at AUD/CNY 5.09. Should the mining company use the futures market to hedge the exchange rate exposure? Explain why or why not?

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Answer #1

Yes, the mining company should use futures to hedge.

Without hedging

AUD received after 3 months = amount in CNY / expected spot rate in 3 months

AUD received after 3 months = 500,000,000 / 5.13 = AUD 97,465,887

With hedging

AUD received after 3 months = amount in CNY / futures contract price today

AUD received after 3 months = 500,000,000 / 5.09 = AUD 98,231,827

With hedging, the AUD received after 3 months is higher. Hence, the companys should use futures to hedge

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