Question

25.Your firm (an Australian firm) makes a sale to a Japanese customer.  The sale price is 200 million Japanese Yen payable in exactly three months from today.  The current exchange rate is AUD/JPY = 90 (i.e., 1 Australian Dollar (AUD) is worth 90 Japanese Yen (JPY)). The current interest rates in Australia and Japan are 3% p.a. and 0.5% p.a., respectively.
Given this information, please answer the following questions. Please label your answers according to parts.
(a) Given that Australian Dollar is the domestic currency, what is the direct quote of the exchange rate between Australian Dollar and Japanese Yen ? Please round the final answer to five decimal places.
(b) What is the theoretical current forward exchange rate quoted directly in terms of Australian Dollar (i.e. JPY/AUD) for delivery three months from today ? Show your input to the formula to arrive at the final answer.  Please round the final answer to five decimal places.
(c) How can the firm take advantage of any decreases in the exchange rate and also ensure that it receives at least Australian $2 million ? (Hint: Which derivative instrument can be used to achieve this objective?)
(d) Ignoring the cost of the derivative instrument to be used in part (c), what would be the outcome from hedging if the spot exchange rate in 3 month’s time is (i) AUD/JPY=150 and (ii) AUD/JPY = 50?

27.Your uncle has a big proportion of his life savings deposited in one of the Big Four Australian banks. He read in the newspaper that due to COVID-19, these banks’ profitability has declined significantly as a result of some customers not being able to service their loans and negative economic outlook. He is worried that his deposit in the bank may not be secure and is wondering whether he should withdraw all his deposit from the bank. Knowing that you have just completed this unit, he asked for your advice.
What advice will you provide to your uncle given what you have learned about financial institutions in this unit?

23.Having observed the dramatic rebound of technology stocks from their lows in March 2020, your friend Jake believes that this rally of technology stocks is simply too good to be fundamentally true given the ongoing significant economic impact of COVID-19. Accordingly, he has borrowed 50,000 shares of Cooper Technologies Ltd from his broker and sold them all at the price of $21.08 per share.
Explain the rationale behind Jake’s investment strategy. What is the risk that Jake faces that might keep him awake at night ?

Answer 1

25a). Direct quote (JPY/AUD) = 1/indirect quote = 1/90 = 0.01111

ie. 1 JPY = 0.01111 AUD (direct quote)

b). Theoretical current forward exchange rate is

spot rate*(1 + 3 month AUD rate)/(1 + 3 month JPY rate)

= 0.01111*(1+ 5%/4)/(1+0.5%/4) = 0.01118 AUD per 1 JPY (or JPY/AUD = 0.01118)

c). If the firm is expecting the exchange rate to depreciate then the Yen receivable of 200 million can be hedged by buying a put option at a strike of 1JPY/AUD 0.01111.

After 3 months,

-- if the rate falls below JPY/AUD 0.01111 then, payoff will be AUD 0.01111*200 million or AUD 2,222,222.22

-- if the rate goes above JPY/AUD 0.01111 then payoff will be the AUD market rate*200 million. (Note: Cost of put option will have to be deducted in both scenarios)

d-i). AUD/JPY = 150 or JPY/AUD = 1/150 = 0.00667

In this case, the put option will be exercised and proceeds will be 0.01111*200 million = AUD 2,222,222.22

d-ii). AUD/JPY = 50 or JPY/AUD = 1/50 = 0.02000

In this case, the put option will not be exercised and proceeds will be 0.02000*200 million = AUD 4,000,000