Question

You are a handicraft dealer in Australia and import materials from New Zealand. You have accounts payable to your suppliers from New Zealand in New Zealand Dollars.

1.)a.) Explain the exposure risk your company will face if you do not hedge transactions?

b.) If you hedge, which hedging method would you use? (Forward Market Hedge, Money Market Hedge,Options Market Hedge,Cross-Hedging Minor Currency Exposure,Hedging Contingent Exposure or Hedging Recurrent Exposure with Swap Contracts)

State your reason why?

Answer 1

1) Since we are a handicraft dealer in Australia and sourcing supplies from New Zealand, our payment liability is towards the supplier in New Zealand and is in the currency of New Zealand. Any fluctuation in the currency exchange rate between the currencies of Australia and New Zealand with a depreciation of Australian dollar would result in increased payment obligations. Thus hedging is required to ensure that payment obligations are frozen at a particular exchange rate. If we do not hedge transactions, the payable liability would significantly increase in case of adverse change in exchange rates and this would create would create unfavourable exposure for the firm.

2) If we are going to hedge these labilities, then we would go for plain vanilla forward contract using a forward market hedge. Since we are a small corporation and a net importer, we would go for a forward contract mechanism as the complexities are less, premium paid would be less and the hedging is complete removing any scope of adverse effect of any fluctuation of currency.