Managing Foreign Exchange Exposure. A client for who you provide financial advice has come to you for guidance over a foreign exchange transaction. The client’s company, based in Australia has sold US$2,000,000 of machine parts to a US customer. The payment has been deferred for six months. Spot exchange rate = US$1.0252/AU$ Six month forward rate = US$1.0468/AU$ Company’s cost of capital = 12.0% p.a. US 6-month deposit rate = 6.0% p.a. US 6 month borrow rate = 9.5% p.a. Australian 6-month borrowing rate = 7.0% p.a. Australian 6 month deposit rate = 4.0% p.a. Six month call option for US$2,000,000; strike price $1.055/AU$, premium price is 1.5% The company’s forecast for 6 month spot rate is $1.0500/AU$
Explain and calculate the process of hedging the transaction exposure using a money market hedge.(Show workings)
Explain the role of interest rate differentials in your calculation in d) and calculate the implicit interest rate that would make you indifferent between the forward exchange contract and the money market hedge.
Calculate and explain the process of covering the transaction’s exposure through the options market.
Based on your calculations above, which alternative would you recommend and why?