Question

A US multinational received an order for airplane parts from Australia for delivery in one year. The total invoice is A$1,000,000 and payable in six months. The expected spot prices to prevail in six months range from $0.55 to $0.85. The following information is available:

Spot rate                                  $0.70/AUD
6-month forward rate           $0.68/AUD.
Interest rate in US4.00%
Interest rate in Australia8.00%
Call option premium$0.12E=$0.70
Put Optionpremium$0.10 E=$0.70

1. How can the firm hedge using forward rates? Show the payoffs for the expected spot rates.
2. How can the firm hedge using money market rates? Show the payoffs for the expected spot rates.
3. How can the firm hedge using options. Show the payoffs for the expected spot rates.
4. Which hedging would you recommend?

Answer 1

1]	The can enter into a forward contract for sale of
	A$1,000,000 after 6 months at the rate of $0.68/AUD.
	The amount receivable would be: 1000000*0.68 =	$             680,000
2]	For the MMH, the strategy would be create a liability
	in A$, such that it would have a maturity value of
	A$1,000,000 in 6 months. For that, the firm should
	borrow AUD 1000000/1.04 =	961538	AUD
	[It is assumed that the given interest rates are per
	annum. Hence, half yearly rates are USD 2% and AUD 4%]
	The borrowing in AUD of 961538 will have a maturity value
	of AUD1,000,000 [with interest of 4%]
	The AUD of 961538 will be converted to $ to get: 961538*0.70 =	$             673,077
	This amount in $ will be deposited for 6 months to get = 673077*1.02 =	$             686,538
	The MV value of the deposit will be the amount receivable.
3]	The firm should go for a put option on A$1,000,000 with a
	premium of $0.10 per AUD, and strike rate of $0.70/AUD.
	The premium payable upfront = 1000000*0.10 =	$             100,000
	The option will be exercised, if the future spot is 0.70 or less.
	Then the amount receivable on exercising the option will be:1000000*0.70 =	$             700,000
	Less: FV of the premium = 100000*1.02=	$             102,000
	Net receivable	$             598,000
	If the future spot is more than 0.70$/A$, then the option will
	not be exercised and the net amount would be: 1000000*Future spot rate-$102000
4]	Of the three options, the MMH would give the highest possible
	receipt in the worst condition.