Question

Assume it is Sept 1, 2020. Company ABC using AUD as functional currency is concerned about currency risk. The company imports goods from the US and sells them in the Australian market with expected revenues for 2021 of AUD 11.5 million. The contract price for these goods from US suppliers is USD 6.5 million payable in one payment on March 1, 2021. The company has a target profit margin (profit as percentage of revenue) of 20%. The minimum acceptable profit margin below which the company will have difficulties servicing its debt is 15%. The spot AUD/USD rate on Sept 1, 2020 is 0.70. The Australian and US six-month interest rates are 2.5% and 2.0%, respectively. Furthermore, the following option contracts expiring on March 1, 2021 are currently available:

Strike AUD/USD rate           Premium

AUDCall 0.73                        0.015

AUDCall 0.68                        0.021

AUDCall 0.70                        0.017

AUDPut 0.72                       0.0125

AUDPut 0.68                        0.008

AUDPut 0.65                        0.005

Based on this information and the knowledge you gained while studying the FRM unit, respond to the questions below. Give all your answers for profit margins and currency rates with 4 (four) decimal places Problem

1. The company analyses the following hedging strategies for managing currency risk:
Strategy I: No hedge at all.
Strategy II: Hedging 100% of the currency exposure with a forward contract.
Strategy III: Hedging 40% of the currency exposure with a forward contract and leaving the remaining 60% unhedged.
Strategy IV: A strategy to meet the target rate and benefit from favourable exchange rate movements.
Strategy V: A strategy for worst-case protection only.

Strategy VI: Using a collar involving the put with the AUD/USD strike rate at 0.68 and the call with the AUD/USD strike rate at 0.73.
For each of these strategies:
 Calculate the profit margin and effective currency rate if the AUD/USD spot exchange rate on 1 March 2021 is:
a) 0.75,
b) 0.63.
 What are the advantages and disadvantages of each hedging strategy?
 If a strategy includes options, state clearly which option contract should be used, whether as a long or short position, and why.

2. Apart from the information provided above and the conducted analysis of the six hedging strategies, what further information would the company need in order to decide which hedging strategy should be adopted?

Answer 1