BAFI1018 Final Assessment: You Work For Firm XYZ Situated In ✓ Solved

BAFI1018 Final Assessment You work for firm XYZ situated in Australia, and your boss has become concerned about the current economic environment, especially as it relates to the different types of exposures that your firm may face in the near future. You are asked to provide a report, which evaluates how your firm is exposed, and what are possible hedging strategies. You are also to provide a recommendation for what your firm should do.

Identify and analyze the various types of financial and economic exposures that Firm XYZ faces given its operations and the current macroeconomic environment. Evaluate appropriate hedging strategies to mitigate these risks, considering currency risk, interest rate risk, and economic factors influenced by economic growth and monetary policy. Use the provided exchange rate data, forward rates, option premiums, and economic information to support your analysis. Finally, recommend the most suitable hedging approach based on your findings and justify your choice, considering potential outcomes and risk management objectives.

Sample Paper For Above instruction

Introduction

In an increasingly globalized economy, firms engaged in international trade are exposed to various financial risks, including foreign exchange risk, interest rate risk, and economic exposure. For Firm XYZ, based in Australia, these risks are significant due to its operations involving payments and receivables in different currencies, alongside its strategic financial decisions such as issuing bonds in USD. The economic environment—characterized by potential monetary easing by the Reserve Bank of Australia (RBA), declining foreign economic growth, and currency market fluctuations—further influences these exposures. This report evaluates the types of exposures faced by XYZ, explores appropriate hedging strategies, and provides informed recommendations for effective risk management.

Identifying and Analyzing Exposure Types

1. Transaction Exposure

Transaction exposure arises from the settlement of specific foreign currency transactions. For XYZ, this includes a EUR payable of €400,000 due in three months and a USD receivable of $300,000 due in four months. Fluctuations in EUR/USD and USD/AUD exchange rates can impact the firm's cash flows. The EUR payable exposes the firm to currency risk, potentially increasing costs if the EUR appreciates against the AUD, while the USD receivable's value in AUD may fluctuate, affecting expected revenue.

2. Economic Exposure

Economic exposure reflects the impact of exchange rate changes on the firm's market value, competitiveness, and future cash flows. Given that XYZ exports goods to foreign markets experiencing slower growth, depreciation of the domestic currency (AUD) might make exports more competitive, potentially offsetting some negative impacts. However, the decline in foreign economic growth could reduce demand, negating these benefits. The anticipated expansionary monetary policy by the RBA could lead to a depreciating AUD, affecting the firm’s export revenues and import costs.

3. Translation Exposure

This relates to the impact on reported financial statements due to currency movements affecting foreign assets, liabilities, or income statement items. While not explicitly detailed, it is relevant if the firm reports consolidated financials involving foreign operations or assets denominated in foreign currencies.

4. Interest Rate Risk

The firm’s consideration to issue USD bonds with a one-year maturity introduces interest rate risk, particularly if global or U.S. interest rates fluctuate due to monetary policy shifts. Changes in interest rates can affect the cost of borrowing and influence exchange rates, further complicating hedging decisions.

Implications of the Economic Environment

The RBA's potential move towards expansionary monetary policy, involving lowering the cash rate, is likely to weaken the AUD, influencing currency risk exposures directly. Simultaneously, slower foreign economic growth reduces demand for exports, affecting revenue streams. Forecasts of exchange rates—such as AUD/USD and EUR/AUD—are crucial for planning hedging strategies.

Bank forecasts indicating a potential depreciation of AUD/USD in three to four months suggest that forward contracts could be advantageous. Furthermore, the decline in foreign growth reduces the likelihood of currency appreciation, emphasizing the need for proactive hedging.

Hedging Strategies and Evaluation

1. Forward Contracts

Enter into forward contracts to lock in exchange rates for the EUR payable (€400,000 in 3 months) and USD receivable ($300,000 in 4 months). Based on the current forward rates provided, we can calculate the potential costs or gains of these hedges and compare them with expected spot rates.

2. Currency Options

Use currency options (puts and calls) to hedge against adverse currency movements while maintaining upside potential. For example, purchasing a put option on EUR/USD allows XYZ to sell EUR at a predetermined rate if the EUR appreciates, thus limiting downside risk. Similarly, options on USD/AUD can protect against unfavorable USD movements.

3. Interest Rate Swaps or Hedging Bonds

If XYZ proceeds with issuing USD bonds, interest rate swaps or fixed-rate bonds can lock in borrowing costs, shielding from rate volatility. Analyzing current interest rate spreads and economic forecasts informs whether fixed or floating-rate borrowing is more advantageous.

Calculations of Hedge and No-Hedge Scenarios

Assuming the current spot rate for EUR/USD is S=1.6 and for AUD/USD is 1.35, we use the forward rates and premiums to evaluate potential outcomes. For example, if XYZ enters a forward contract to buy EUR at a forward rate of S+0.02 (i.e., 1.62), the firm locks in costs, avoiding exchange rate fluctuations.

Alternatively, if the expected spot rate in three months (from forecasts) is S=1.65, and the forward rate is 1.62, hedging at the forward rate results in a net saving per euro (or dollar). The decision to hedge depends on the comparison between forward rates and forecasts.

Should the Firm Hedge?

Given the current macroeconomic uncertainties and currency forecasts, hedging appears prudent. Locking in exchange rates reduces cash flow unpredictability, especially considering the potential decline in the AUD and foreign currencies’ depreciation. Hedging allows XYZ to plan and set accurate financial targets, minimizing the impact of unfavorable market movements.

Recommendation

Based on the analysis, the most appropriate strategy is to employ a combination of forward contracts for the EUR payable and USD receivable, supplemented by options to hedge against extreme currency movements. Specifically, forward contracts provide certainty for the upcoming payments and receipts, while options add flexibility and protection against unforeseen adverse shifts.

Additionally, if XYZ proceeds with issuing USD bonds, fixed-rate issuance or interest rate swaps should be considered to mitigate interest rate and currency risks. These strategies collectively align with risk management objectives, especially under volatile economic conditions.

Conclusion

XYZ faces significant transaction and economic exposures driven by currency fluctuations, interest rate risks, and macroeconomic dynamics. Employing hedging instruments such as forward contracts and options is advisable to mitigate these risks. Considering current forecasts and economic indicators, a combined hedging approach offers optimal protection while maintaining flexibility. This strategic risk management enables XYZ to stabilize cash flows, enhance financial predictability, and sustain competitiveness amidst uncertain economic conditions.

References

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