Question

The a2 Milk Company (ATM) wants to hedge against the foreign exchange (FX) risk of its sales revenue in Chinese Yuan Renminbi (CNY) as the majority of its operating expenses are denominated in New Zealand Dollar (NZD). The company expects to receive 30 million in CNY in exactly 6 months.

Required:

1. Suppose that ATM has decided to use a “money market hedge”, i.e., to transform its future CNY revenue into NZD by trading in the spot CNY/NZD market as well as borrowing/lending NZD and CNY. Using the information provided below, determine the equivalent NZD amount of the company’s revenue (of 30 million CNY) that it will receive in 6 months, after the company employs the money market hedge. Discuss the procedures that the company should take so as to obtain the NZD-equivalence revenue. Express your answer in thousands with 3 dps.

Spot CNY/NZD FX rates		6M NZD interest rates		6M CNY interest rates
Bid	Ask	Deposits	Lending	Deposits	Lending
4.5496	4.5523	3.20% p.a.	5.25% p.a.	1.55% p.a.	4.35% p.a.

Note: the interest is compounded semi-annually.

2. Now suppose that a local bank offers ATM the following six-month CNY/NZD FX rates: 4.5313/4.5649 (bid/ask). Should the company conduct a “forward hedge”, i.e., enter a forward contract with the bank, or go for the “money market hedge” as in part (a)? Support your answer with numerical calculations. Ignore all transaction costs other than the bid/ask spreads of FX and interest rates.

Answer 1

a]

To hedge its CNY revenue, ATM will take the following steps :

• Borrow an amount equal to the present value of 30 million CNY (discounted for 6 months at the CNY lending rate)
• Convert the borrowed amount into NZD at the spot rate
• Deposit the converted amount at the NZD deposit rate for 6 months
• Use the 30 million CNY receipt after 6 months to repay the borrowed amount

Amount borrowed in CNY = 30 million / (1 + 4.35%)^6/12 = CNY 29,346,959

CNY 29,346,959 is converted into NZD at the spot rate. Converted amount = CNY 29,346,959 / 4.5523 = NZD 6,446,622

NZD 6,446,622 is deposited at the NZD deposit rate for 6 months.

Amount received after 6 months = NZD 6,446,622 * (1 + 3.20%)^6/12 = NZD 6,456,783

NZD amount of the company’s revenue =  6,456,783

b]

Amount received after 6 months with forward hedge = 30 million / 4.5649 = NZD 6,571,885

The company should conduct a forward hedge as the amount in NZD received after 6 months is higher with a forward hedge as compared to a money market hedge