Question

(a) Asume that an Australian company has a USD 500,000 receivable due in 12 months, but the company is concerned that it will get less in AUD if the Australian dollar appreciates in 12 months' time. Given today's data Spot Rate: AUDIUSD 0.7430-35 Money market rates: 70% pa in Australia 5.0 % in the United States Explain how you would use the money market (BSI) hedging strategy to cover the USD receivable risk. Clearly describe today's transactions and the transactions in 12 months' time. Show all workings Explain what would happen to the value of the company's value of its USD receivable in terms of AUD received in 12 months' time if the hedging strategy outlined in part (b) above had not been put in place (b)

Answer 1

(BSI) HEDGING STRATEGY TO COVER THE USD RECEIVABLE RISK:

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market, in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances and commercial paper are traded. Since there are a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk; however, for retail investors or small businesses looking to hedge currency risk the money market hedge is one way to protect against currency fluctuations without using the futures market or entering into a forward contract.

Let’s begin by reviewing some basic concepts with regard to forward exchange rates as this is essential to understand the intricacies of the money market hedge.

A forward exchange rate is merely the spot exchange (benchmark) rate adjusted for interest rate differentials. The principle of “Covered Interest Rate Parity” holds that forward exchange rates should incorporate the difference in interest rates between the underlying countries of the currency pair, otherwise an arbitrage opportunity would exist.

Money Market Hedge Applications:

1. The money market hedge can be used effectively for currencies where forward contracts are not readily available, such as exotic currencies or those that are not widely traded.
2. This hedging technique is also suitable for a small business that does not have access to the currency forward market as noted earlier.
3. The money market hedge is especially suitable for smaller amounts of capital, where someone requires a currency hedge but is unwilling to use futures or currency options.

The following basic terms are provided and apply to forward, futures and option contracts:

- Long position: The buying of a security or currency with an expectation that the value of the asset will rise. In the context of derivatives, it is the buying of a derivative contract. The long position agrees to buy the underlying asset at the specified price on the specified date.

- Short position: In the context of derivatives, the seller or writer of the contract is said to have a short position. The short position agrees to sell the underlying asset at the specified price on the specified date.
- Underlying asset: The asset/ currency specified in the contract.
- Maturity date: The specified date on which the trade will take place or the date of expiration of the contract.
- Delivery price/ Exercise price: The price specified in the contract, at which the specified trade of the underlying contract will take place.

(a) Taking the above example, assume U.S. company offer a 12 months interest rate on U.S. dollar (USD) for deposits of 5% p.a. and an Australian company offers an interest rate of 7% p.a. on Australian-dollar (AUD) deposits. Although U.S. investors may be tempted to convert their money into Australian dollars and place these funds in AUD deposits because of their higher deposit rates, they obviously face currency risk. If they wish to hedge this currency risk in the forward market by buying U.S. dollars one year forward, covered interest rate parity stipulates that the cost of such hedging would be equal to the 2% difference in rates between the U.S. and Australia.

We can take this example a step further to calculate the one-year forward rate for this currency pair. If the current exchange rate (spot rate) is US$ 1 = AUD$ 0.7430, then based on covered interest rate parity, US$ 35 placed on deposit at 5% should be equivalent to AUD$ 0.7430 at 7% after one year.

Thus, it will be shown as: US$ 1 (35 + 5%) = AUD$ 1 (0.7430 + 7%) or US$ 1 40 = AUD$ 1 7.7430

the one-year forward rate is therefore:

US$1= AUD$ 7.7430 ÷ 40 = AUD$ 0.193575

Note that the currency with the lower interest rate always trades at a forward premium to the currency with the higher interest rate. In this case, the U.S. dollar (the lower interest rate currency) trades at a forward premium to the Australian dollar (the higher interest rate currency), which means that each U.S. dollar fetches more Australian dollars (0.193575 to be precise) a year from now, compared with the spot rate of 0.7430.

If a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market:

1. Borrow the domestic currency in an amount equivalent to the present value of the payment.
2. Convert the domestic currency into the foreign currency at the spot rate.
3. Place this foreign currency amount on deposit.
4. When the foreign currency deposit matures, make the payment.

Note that although the entity who is devising a money market hedge may already possess the funds shown in step 1 above and may not need to borrow them, there is an opportunity cost involved in using these funds. The money market hedge takes this cost into consideration, thereby enabling an apples-to-apples comparison to be made with forward rates, which as noted earlier are based on interest rate differentials.

(b) From the perspective of the Australian company, the domestic currency is the Australian dollar and the foreign currency is the US dollar. Here’s how the money market hedge is set up.

1. The Australian company borrows the present value of the U.S. dollar receivable (i.e. US$ 500,000 discounted at the US$ borrowing rate of 5%) = US$ 500,000 / (5) = US$ 100,000. After one year, the loan amount including interest at 5% would be exactly US$ 100,000.
2. The amount of US$100,000 is converted into Australian dollars at the spot rate of 5%, to get AUD$ 500,000.
3. The Australian dollar amount is placed on deposit at 7%, so that the maturity amount (after one year) = US$ 500,000 x (7) = AUD$ 350,000.
4. When the export payment is received, the Australian company uses it to repay the U.S. dollar loan of US$500,000. Since it received AUD$ 350,000 for this U.S. dollar amount, it effectively locked in a one-year forward rate = AUD$ 350,000/ US$ 500,000 or US$ 1 = AUD$ 0.7.

Why would the Australian company use the money market hedge rather than an outright forward contract? Potential reasons could be that the company is too small to obtain a forward currency facility from its banker or perhaps it did not get a competitive forward rate and decided to structure a money market hedge instead.

The money market hedge is an effective alternative to other hedging tools such as forwards and futures as a means to mitigate currency risk. It is also relatively easy to set up, as one of its only requirements is to have bank accounts in a couple of different currencies. However, this hedging technique is more difficult due to its number of steps and its effectiveness may also be impeded by logistical constraints, as well as actual interest rates that are different from institutional rates. For these reasons, the money market hedge may be best suited for occasional or one-off transactions.

(b) Hedging is defined here as risk trading carried out in financial markets. Businesses do not want market-wide risk considerations – which they cannot control – to interfere with their economic activities. They are, therefore, willing to trade the risks that arise from their daily conduct of business. Whether in industrial, commercial or financial businesses, the financial
assets – loans, bonds, shares, stocks, derivatives – they trade allow them to hedge the risks that accumulate in their balance sheets in the course of business. From the point of view of the corporates and other firms trading in these risks has been also very much at the center of financial developments.

Hedging transfers risk, in our case foreign exchange risk, from market participants wishing to avoid it to those willing to assume it. In principle a hedge is effective if it eliminates the cash flow uncertainty or price risk associated with a future transaction. This is achieved when the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent. In other words, the hedging contracts change in value is opposite to the change in value of the currency exposure. These two amounts offset each other so that the hedger can obtain revenue or cost certainty. According to the accounting standard, FAS 1331, there are various ways to test for hedge effectiveness. This thesis will focus on one of the methods known as the regression method. The Regression Method uses regression analysis to test for an R² of at least 80% in order for a hedge to be considered effective. R² refers to the variance in the hedging instrument that is explained by the variance in the hedged item or underlying.

The popularity and logical reasons for hedging foreign exchange rate risk is clear; however, the effectiveness of hedging strategies in emerging markets is not as clear cut. The possible problems that might arise from attempts to hedge using futures contracts that are being tested in this article are:
• If a suitable futures market exists for the currency, will the illiquidity in the futures market mean that the futures price will not be sufficiently correlated to the underlying currency and thus mean an ineffective hedge. In other words, will mispricing of the futures contracts occur and will this create an ineffective hedge? Similarly, another consequence of illiquidity is the limited range of maturity dates available for futures contracts. As a result the investors’ date of market commitment will often not coincide with the available maturity dates. The mismatch in maturity dates is referred to as delivery basis risk. Delivery basis risk implies that the hedge will not be perfect.

It is important to keep in mind that in the extreme case of zero correlation between spot and futures price changes, there is no offsetting of risks at all from hedging using futures contracts. Any hedging activity will only increase overall cash flow and price risk by creating uncertainty from a second source, namely the futures position. It is only when the correlation of spot and futures price changes are perfect (no basis risk) that a riskless hedge is obtained without the use of an optimal hedge ratio. It will also be shown that the effectiveness of the hedge is tied to the correlation between the spot and futures price
changes and the minimum variance hedge ratio.

Although forward markets can help to eliminate the above problems and for that reason are the most popular contracts used for hedging purposes, hedging with forwards also has its disadvantages. Most noticeably, finding a counter-party can be a lengthy process and potentially costly. Forwards are less liquid in that if the need to remove the hedge arises forwards cannot be sold prior to expiration. Moreover futures, unlike forwards, provide leverage and therefore with futures it is possible to hedge a big amount with a smaller outlay.

In conclusion the pros and cons of money market hedge:

1. The money market hedge, like a forward contract, fixes the exchange rate for a future transaction. This can be good or bad, depending on currency fluctuations until the transaction date.
2. The money market hedge can be customized to precise amounts and dates. Though this degree of customization is also available in currency forwards, the forward market is not readily accessible to everyone.
3. The money market hedge is more complicated than regular currency forwards, since it is a step-by-step deconstruction of the latter. It may therefore be suitable for hedging occasional or one-off transactions, but as it involves a number of distinct steps, may be too cumbersome for frequent transactions.
4. There may also be logistical constraints in implementing a money market hedge. For instance, arranging for a substantial loan amount and placing foreign currencies on deposit is cumbersome and the actual rates used in the money market hedge may vary significantly from the wholesale rates that are used to price currency forwards.