a2 Milk Ltd Pty. a2 Milk is an Australian company specialising in producing fresh milk and...

a2 Milk Ltd Pty.

a2 Milk is an Australian company specialising in producing fresh milk and milk formula. The company has its operations in Australia. Therefore, there expenses are generally invoiced in Australian dollars (AUD). However, it has recently imported supplies from New Zealand, and the bill is invoiced in the New Zealand dollars (NZD) for NZD 1,500,000, payable in 6 months’ time.

Suppose a2 Milk’s management is concerned about foreign exchange rate exposure, and would like to hedge this risk. Suppose also that you observe the following quotes in the foreign exchange market:

Currency		In USD	Per USD
AUD	Spot	0.7289	1.3719
	1-month forward	0.7280	1.3736
	3-month forward	0.7264	1.3767
	6-month forward	0.7242	1.3808
NZD	Spot	0.6759	1.4795
	1-month forward	0.6763	1.4786
	3-month forward	0.6785	1.4738
	6-month forward	0.6800	1.4706

The banker offers to set up a forward hedge based on the NZD/AUD forward cross-exchange rate implicit in the forward rates against the dollar. Suppose you are a risk manager at a2 Milk. You are required to advise the CEO the following:

The AUD equivalent of this transaction at the current spot exchange rates. (Could you explain in details and step by step)
The foreign exchange rate risk exposure of this transaction. (Could you explain in details and step by step)
Whether the company should hedge. If so, show the CEO how you would hedge this risk exposure with the available forward contracts. (Could you explain in details and step by step)

Solutions

Expert Solution

Answer for (25 Marks)

First thing first, a2Milk Ltd Pty has to pay in next 6 months. It is always better to enter into a forward contract in such a situation as the trend shows spot payment makes conversion cost more for the company. Hence company would enter in 6 months forward contract.

here for 6 months forward. The AUD/USD rate is 0.7242/1.3719 i.e. 1 USD is 0.5249 AUD

and for 6 months forward. The NZD/USD rate is 0.6800/1.4706 i.e. 1 USD is 0.4623 NZD

thus 1 AUD is equal to 0.8807 NZD.

so in 6 months forward contract the amount to be paid by a2 Milk Ltd Pty will be 1500000*0.8807 = 13,21,050

Answer for (10 Marks)

the foreign exchange market risk includes change in trade policies, change in value of foreign currency i.e. NZD

if the value of NZD increases in the period of 6 months then the company will have to pay higher amount where as entering into forward contract helps to hedge that risk.

There is still possibility of breach of contract by the opposing party.

It can be observed that AUD is stronger currency compared to NZD thus entering into forwards contract in USD will be beneficial for the company as there is probability of increase in value of AUD thus making AUD stronger in forex market and would be lesser in cost.

Answer for (5 Marks)

has been solved. for 25 marks.

jeff jeffy answered 1 year ago

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