Question

Question 5: Managing Foreign Exchange Exposure Ashton Ltd, a client to whom you provide financial advice has come to you for guidance over a foreign exchange transaction. The company, based in New Zealand has sold USD 2,000,000 of machine parts to a USA customer. The payment has been deferred for six months. The following information is relevant: Spot exchange rate = 1.724/USD Six month forward rate = 1.717/USD Company's cost of capital 12.0% p.a. US deposit rate 6.0% p.a. US lending rate 7.0% p.a. New Zealand - lending rate 6.0% p.a. New Zealand - deposit rate 5.0% p.a. Risk free rate in New Zealand = 2.0% p.a. Risk free rate in the USA = 4.0% p.a. Required: a) Calculate the expected spot rate in 6 months assuming that the interest rate parity between the two countries holds. b) Calculate the expected value of the sales proceeds in NZD using the expected spot rate computed in (a) above. c) Calculate and value of the proceeds from the sale if the company enters into a forward rate agreement. d) Explain and calculate the net proceeds receivable by Brian's company if money market hedge is used.(Show workings) c) Based on your calculations above, which alternative would you recommend and why?

a) Calculate the expected spot rate in 6 months assuming that the interest rate parity between the two countries holds.

b) Calculate the expected value of the sales proceeds in NZD using the expected spot rate computed in (a) above.

c) Calculate and value of the proceeds from the sale if the company enters into a forward rate agreement.

d) Explain and calculate the net proceeds receivable by Brian's company if money market hedge is used.(Show workings)​​​​​                  

e) Based on your calculations above, which alternative would you recommend and why?​

Answer 1

(a) expected spot rate in 6 months (Interest rate parity) Given, spot Mate 1 USD = NZD 1.724 Expected spot rate : 1 USD N 2 (1+RAED) (It Ruso) - Spot salex O de 1 USD 1.724 (1 + 2 x 6 ) 1.724 (1+0.01) a (1+0.02) E TUSD 2 NZD 1.707 expected value of sales (b) using Expected spot rate $ 20,00,000 X 1-707 (C) ZNZD 34,14,000 forward tate agreements to forward Mate (6 months) TUSD = 1.717 NZD Expected value of sales USD 2900,000 x 1.717 NZD 34,39,000

d) Money Moukt hedge; $ Exposwie-us$ 20,00,000 - Receivable & Borrow 1. Identify: USD 20,00,000 is an Asset 2. Coreale: liability in USD 3. Borrows in USD. The borrowing rate is 7% pa. (09) 3.5% per 6 months Amount to be borrowed USD 20,00,000 (1+0.035) Z USD 19,32,367.15 5. convert: Sell USD and buy NZD at spot rate $ NZD 1.724 Amount of NZD received not 219,32,367.15 x 1724 - 33,31,40097 NZD 6. Invest: NZD 33,31, 400.97 will be invested at 5% for 6 months and get 34, 14,685.99 NED ( 33,31,400.97(1+0.025)) 7. settle: The Liability of USD 19, 32, 367.15 at interest of 3.5% for 6 months matures to 4 USD 20,0O0OO (OSD 1,334.15x(+0.035) Arxcunt received through money NZD 30 market hedge NLD 34, 14,685.99. on conversion

Alternative Expected spot rate (6) forward rate (c) Money market hedge (d) (Rounded off) Amount (NZD 34,14,000 34,34,000 34, 14, 686 forward rate is recommended since the amount receivable is maximum in forward rate agreement when compared to other alternatives.