Question24 Assume that we have:Spot exchange rate: AUD 1.50 per USDOne-year forward rate: AUD 1.55 per USDRisk-free interest rate in USD: 3% (annualized)Risk-free interest rate in AUD: 5% (annualized) (1) A company has to pay a cost of USD 1 million to its supplier next year. Should the company hedge with a forward contract or do the money market transaction? Present value of cost if using forward = AUD [input] million (1 point)Present value of cost if using money market transaction = AUD [input] million (1point)The company should choose[select: , Forward contract, Indifferent between the two, Money market transaction] (1 point) (2) A company will receive a revenue of USD 1 million from its customer next year. To better hedge the exchange risk, what can the company do (purchase forward contracts or hedge by money market transactions)? Present value of revenue if using forward = AUD [input]million (1 point)Present value of revenue if using money market transaction = AUD [input]million (1 point)The company should choose [select: , Money market transaction, Forward contract, Indifferent between the two] (1 point) Note: (1) Round your answers to 3 decimal places, unless the result is an integer.(2) Keep at least 4 decimal places during your calculations to ensure accurate rounding in the final results.(3) You will get 8 points if all the answers are correct. ResetMaximum marks: 8 Flag question undefined

[select: , Forward contract, Indifferent between the two, Money market transaction]

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Question24 Assume that we have:Spot exchange rate: AUD 1.50 per USDOne-year forward rate: AUD 1.55 per USDRisk-free interest rate in USD: 3% (annualized)Risk-free interest rate in AUD: 5% (annualized) (1) A company has to pay a cost of USD 1 million to its supplier next year. Should the company hedge with a forward contract or do the money market transaction? Present value of cost if using forward = AUD [input] million (1 point)Present value of cost if using money market transaction = AUD [input] million (1point)The company should choose[select: , Forward contract, Indifferent between the two, Money market transaction] (1 point) (2) A company will receive a revenue of USD 1 million from its customer next year. To better hedge the exchange risk, what can the company do (purchase forward contracts or hedge by money market transactions)? Present value of revenue if using forward = AUD [input]million (1 point)Present value of revenue if using money market transaction = AUD [input]million (1 point)The company should choose [select: , Money market transaction, Forward contract, Indifferent between the two] (1 point) Note: (1) Round your answers to 3 decimal places, unless the result is an integer.(2) Keep at least 4 decimal places during your calculations to ensure accurate rounding in the final results.(3) You will get 8 points if all the answers are correct. ResetMaximum marks: 8 Flag question undefined

[select: , Forward contract, Indifferent between the two, Money market transaction]

BlackTom AI · Accepted Answer

We start by parsing the given data and what is being hedged in each part.
Key data: Spot rate = AUD 1.50 per USD, 1-year forward = AUD 1.55 per USD. USD risk-free rate = 3% annually, AUD risk-free rate = 5% annually.
Part (1): Company has a payment of USD 1,000,000 next year (a foreign currency outflow).
- Forward contract hedge: To lock in the AUD cost of paying USD 1,000,000 next year, the company would enter a forward to buy USD forward (or equivalently set a forward in AUD terms). Since the forward rate is AUD 1.55 per USD, the fixed AUD amount paid next year would be 1,000,000 × 1.55 = AUD 1,550,000. There is no discounting of this amount when using a forward for a single future date; the value is fixed today as the forward contract specifies.
- Money market (natural) hedge: In a money market hedge, you cover the future USD outflow by borrowing (or using) AUD today, converting to USD today at the spot rate, investing the USD for one year, and then using the USD payoff to satisfy the payment next year, while also repaying the AUD loan in AUD after converting back or by matching the cash flows via the hedge. Practically, the amount of AUD needed today to guarantee USD 1,000,000 next year equals the present value of that USD liability in AUD, discounted at the USD risk-free rate and converted via the current spot rate. This gives: PV_AUD = USD_amount × Spot / (1 + r_USD) = 1,000,000 × 1.50 / 1.03 ≈ AUD 1,456,310.679. This approach locks the obligation in AUD terms and uses the interest differential to hedge.
- Option-specific observations:
  • If the company uses a forward, the cost in AUD is fixed at AUD 1.550 million, regardless of future spot movements.
  • If the company uses a money market hedge, the initial AUD outlay is about AUD 1.456 million, which is lower than the forward cost, and it relies on the interest rate differential to determine the hedge payoff.
  • The money market hedge therefore typically yields a lower AUD cost for this USD outflow given the stated rates, and is the more cost-efficient hedging approach in this scenario.

Part (2): Company will receive USD 1,000,000 next year (a foreign currency inflow) and wants to hedge the exchange risk.
- Forward contract hedge: Lock in the amount of AUD to be received by selling USD forward (or buying USD forward to cover the USD inflow in the appropriate direction). The resulting AUD value locked in is 1,000,000 × 1.55 = AUD 1,550,000. This is a fixed amount in AUD regardless of how the spot rate moves over the year.
- Money market hedge: For an USD receivable, a money market hedge would typically involve borrowing USD today, converting to AUD at the spot rate, and investing the AUD proceeds in the domestic money market; in one year, when the USD receivable is collected, the USD loan is repaid with the USD received from the customer, and the AUD investment provides the hedge in AUD terms. The resulting AUD amount from this route is: invest AUD proceeds after converting USD today at spot and growing at the AUD rate, so the eventual AUD amount from the hedge is roughly: (USD_borrowed / (1 + r_USD)) × Spot × (1 + r_AUD). Using the numbers: (1,000,000 / 1.03) × 1.50 × 1.05 ≈ AUD 1,529,124. The exact arithmetic confirms the money market hedge yields a fixed AUD amount close to ~AUD 1.529 million, given the rates.
- Option-specific observations:
  • The forward hedge yields AUD 1,550,000 in fixed terms.
  • The money market hedge yields an AUD amount of approximately AUD 1.529 million, which is slightly lower than the forward hedge under the given rates.
  • Hence, for maximizing the AUD value of the receivable under these conditions, the forward contract provides the higher locked-in amount, making it the more favorable hedge in this scenario.

In summary, for (1): the forward cost is AUD 1.550 million and the money market cost is about AUD 1.456 million; the cheaper hedge is the money market transaction. For (2): the forward hedge yields AUD 1.550 million and the money market hedge yields about AUD 1.529 million; the forward contract is the preferable hedge for maximizing AUD receipts.

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