Question

An Australian exporting company will receive 4m USD in 6 months’ time from sales. The current spot rate is: AUD / USD 0.7066 / 0.7073. Australian interest rates are currently at 1.5% p.a. and U.S. interest rates are at 0.5% p.a. The net interest rate spread in both countries is 3.5% (read this as the borrowing rates are 3.5% higher than the given investment rates above). Design a money market hedge which will remove the FX risk faced by the company, yet not altering the timing of the payment. Clearly show the AUD cash flow in the future.

Answer 1

An Australian exporting company is a foreign currency receiver and he is exposed to foreign currency risk. His currency Australian dollar and he is going to receive US $,he need to hedge using any of the methods like forward rate, currency options, currency futures,money market market hedge etc.

In the given question, money market hedge is asked. In the money market hedge, since we are foreign currency receiver we need make borrowing in same currency, so that the sale proceeds can directly routed for borrowing..Money market hedge steps are as follows

Step-1 : make borrowing in such amount where the sales proceeds in 6 months must be equal to repayment amount of borrowing

= Repayment amount/(1+ periodic interest rate)power n

=4m/(1+4/100*6/12)

=US $3.92

( borrowing rate is 0.5+3.5 =4%)

Step -2 : convert borrowed amount using spot rate

1AUD=0.7066-0.7073

1AUD= 0.7073

(we are buying AUD from bank by selling US $ and bank is selling AUD by buying US$ .we have to think from perspective of left currency I. E AUD .since AUD is selling by bank therefore it is ask rate)

=US$3.92/0.7073

=AUD 5.5436

Step-3: deposit the converted amount in Australia for 6 month and withdraw along with interest

=5.5436(1+1.5/100*6/12)

=5.585 AUD (inflow after 6 months)

Deposit interest rate is 1.5%

Step-4:

The borrowing made in step-1 will be repaid along with interest directly out of foreign currency receivable from the customer