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) What would be the profit margin of the company if the current spot rate is used? Problem

2) What is the AUD/USD currency rate at which the company achieves exactly its target rate? Problem

3) What is the critical AUD/USD currency rate for the company? Problem

4) Give two examples of situations in which the company may not need to hedge its currency risks with derivatives.

Answer 1

1)

Revenue = AUD 11.5 million

Cost = USD 6.5 million

         = AUD (6.5 / 0.7) million = AUD 9.285714 million

Profit Margin % = (Revenue – Cost) / Revenue

    = (11.5 – 9.285714) / 11.5

    = 19.2546% or 19.2546%

2)

Exactly target rate is where the company earns 20% Profit margin

Profit Margin =AUD 11.5 * 20%

= AUD 2.3 million

Cost = Revenue - Profit Margin

        = AUD (11.5 - 2.3) million

        = AUD 9.2 million

Exchange Rate (AUD/USD) = Revenue / Cost

                                    = 6.5 / 9.2

                          = 0.7065

3)

Critical Rate is where the company earns 15% Profit margin.

Profit Margin should be = AUD 11.5 * 15%

     = AUD 1.725 million

Cost = AUD (11.5 - 1.725) million

        = AUD 9.775 million

Critical Exchange Rate (AUD/USD) = Revenue / Cost

   = 6.5 / 9.775

    = 0.6649

4) The situations in which the company may not need to hedge its currency risks with derivatives are

(a) When the company expects the AUD to appreciate against dollar

(b) When the cost of hedging is more than the expected benefit from the hedging