Foreign Currency Risk and Hedging Strategies
A)
Every company which are exposed to international transaction are exposed to foreign currency risk and fluctuations in exchange rates can hamper the profitability of the company (Deng 2020). An organization implies various risk management strategies which including using of forward contracts, options and other derivatives instruments. In the case, we understand that although the service station is not involved in selling products to international markets, but a major part of the company expenses is related to fuel cost which is depended upon imports from foreign countries and international markets. The fuel price is positively correlated to USD oil price and the AUD/USD exchange rate which exposes the service station to volatility in profit margins due to high fuel cost. As expected by the purchase department of the service station the price of the fuel is expected to rise significantly in the near term and the service station needs to hedge the cost of the fuel price going forward. Foreign exchange rates are exposed to extreme volatilities so hedging the risk becomes necessary for the service station. Therefore, we disagree with the statement of the CEO as the station is exposed to currency fluctuation risks in the form of heightened price of fuel. According to the proposal if the rates are hedged the station would be able to buy the fuel at the cost which is known today. The real problem of hedging arrives when the cost of the fuel goes in the opposite direction of the forward hedge implied by the service station. The cost of the fuel may fall in the near future but the service station would have to buy at the forward price suffering a loss. Hence, it becomes important for the company to estimate the change in forward rates of the fuel and the expected changes in the USD/AUD exchange rate.
B)
Interest rate risk refers to the risk of fluctuations in the value of asset or liabilities due to the changes in interest rate environment in the country (Möhlmann 2021). According to the case, Green Electricity is dependent on the government which approves the cost at which the company can sell the service. As the company has a debt of $15 billion it is heavily exposed to the interest rate fluctuations in the economy as with a rise in interest rate the company may have to cough out more cash to honor the interest payment obligations related to the debt. As discussed in the case the interest rate is currently at a very low level which is beneficial for the company and the accountant is suggesting to lock in the interest rate for the next fifteen years. The CEO has queried the strategy on the basis of the fact that locking in interest rates for fifteen years would not be warranted as the regulated return that is set by the government is based on interest rates that are reset every five years. Hence, we agree with the statement of the CEO as hedging the interest rate risk for fifteen years would not be profitable as the revenue structure would change every five years. The alternate solution in which both the accountant and the CEO may agree is hedging the interest rate for every five years till the date on which the interest rates are reset. In order to hedge interest rate for five years, the accountant can make use of instruments like plain vanilla interest rate swap where the company may receive floating and pay fixed amount of interest, swaptions and fixed interest rate swaps.
A)
Interest Rate Risk and Hedging Strategies
According to the case, OZPRTS Co. is exposed to the exchange rate fluctuations regarding the price of aluminium which is a raw material for the company in manufacturing aluminium casings for the client residing in Germany. The company is exposed to the input cost side of the contract entered with the client as increase of decrease in the price of the commodity and the foreign exchange risk related to the exchange rate in which the aluminium is traded globally.
Aluminium is an essential commodity for the automotive and the power transmission industry and is subject to volatility in the price due to global demand and supply factors. The price of the commodity is quoted in USD per ton (Lorgulesco 2016), hence, the company is exposed to the fluctuations in AUD/USD exchange rate and an increase in the price of USD in terms of AUD would financially hurt the company in the form of increased costs of raw material.
The following chart represents the movement in the price of aluminium and the monthly USD/AUD exchange rate for the past one year:
It can be observed from the charts above that the price of Aluminium has been steadily rising since the past one year starting from a level of $2392 per ton to a current price of $3272 per ton. This trend may be detrimental to the operations of the company as it may have to purchase aluminium at an increased cost. For instance, if the company purchases 1000 tons of aluminium, it would have costed the company around (1000×2390.50) $2,390,500 to the company whereas the same quantity today must be purchased at (1000x 3272) $3.272,000 as represented by the graph below:
Since, the CEO of the company has guaranteed to sell the casing at a fixed Euro cost, it cannot pass on the increased cost in the aluminium to the customer in Germany. The company has to bear the brunt of the extra cost on the profitability aspect resulting in falling in profits.
Similarly, the exchange rate between US and Australia is also on the rise making the companies in Australia costlier to purchase dollars for the purpose of making payments. As represented in the graph below it can be understood that the price of USD has fluctuated over the past one year but is on a higher level today compared to what it was in the same period last year.
This trend would also hurt the company since it would cost more to the company to buy US dollars using AUD increasing the cost of aluminium in AUD terms. The total cost of the company would increase significantly due to the effect of rise in Aluminium prices and the rise in USD in terms of AUD.
B)
Hedging to decrease risk has a number of advantages for the investor as It helps to reduce risk by locking up profits ahead of time. By correctly hedging its liabilities, the seller or dealer can withstand a market meltdown. The counterparties can safeguard themselves from price volatility caused by changes in interest rates, currency rates, and other factors.
Case Study: OZPRTS Co.
Derivatives based hedging strategies may be used by the company to control the cost of the aluminium used for the manufacturing of casings. A futures contract is a standardised forward contract that is traded on an exchange and has margin requirements and a daily settlement mechanism. An option is a contract that permits an investor to purchase or sell a certain type of asset at a pre-set price level. A call option entails the seller’s obligation to sell the asset at the option’s strike price if the underlying price rises above the threshold. A put option, on the other hand, is a contract in which the option buyer has the right to sell the asset at the striking price if the underlying price falls below it.
The figure above represents the payoff of a company using futures contract to hedge a position. The company may buy aluminium futures at a pre-set price today and expect the price of the commodity to remain above the futures price. As explained in the figure 1 above if the price of the aluminium rises the gain on the future would offset the total cost of the purchase of the commodity and vice versa. The company can also buy currency futures to lock in the price of US dollars to hedge against the currency fluctuations risk.
The above figure represents the payoff of a call option which the company may buy on the aluminium. If the price of the commodity remains below the strike price of the option, the company would only loose the option premium whereas if the price of the aluminium rises above the strike price the company may exercise the option and buy the commodity at the cheaper price (strike price). Similarly, if the call option is purchased on the price of USD, and the USD remains below the strike price of the option, the company would incur costs in the form of premium payment.
The upfront premium for an options contract is determined by the characteristics of the underlying assets, such as the asset’s volatility. As a result, if the price of aluminium does not rise beyond the strike price, the corporation will lose premium. A futures contract is a two-edged sword in that if the price of aluminium falls below the futures price, the corporation is obligated to fulfil the contract by purchasing the commodity at a higher price than the market price.
The corporation should employ futures contracts to hedge against an increase in the price of aluminium and a rise in the value of the US dollar in terms of the Australian dollar. The major benefit of using a futures contract to hedge against risks is that it gives downside protection without incurring any expenditures. Unlike option contracts, which involve the payment of a premium, the price of futures is initially zero. Furthermore, the options are appropriate for a commodity with a high level of volatility and a premium at the time of contract entry.
C)
On the revenue side of the contract, the company is exposed to the currency fluctuations between the EUR/AUD exchange rate as a fall in the price of the Euro may result in reduced revenue as the company would receive lesser AUD while converting the Euro received from the German client. The following chart represents the price of EUR in terms of AUD:
It is evident from the chart that the EUR is getting cheaper since the beginning of the year 2021 currently trading at 1.4812 AUD per EUR. If this trend was to continue the company would face reduction in the revenue figures as they would receive less AUD while converting the EUR received from the German client.
Assuming the price of the Aluminium casing is EUR 100 and the company has an obligation of delivering 200,000 casings to the client based on EUR/AUD exchange rate. If the transaction was to be complete at the current prevailing EUR/AUD exchange rate of 1.4812, the total AUD receivable for the company would be AUD 296,252.4. If the price of the EUR fell down in the future, for instance to 1.4700, in such case the AUD receivable would reduce to AUD 294,000 which is a fall of 0.76% in revenue. Hence, the company needs to effectively manage the exchange rate exposure on the revenue side to remain less affected with the currency fluctuations.
The corporation should use a futures approach to hedge the currency risk on the revenue side of the deal, selling the EUR forward at today’s pricing. The corporation would be hedged from the profit gained in the futures position if the EUR price fell below the futures price, and vice versa. Futures are a good alternative since they don’t involve any upfront fees and provide complete downside protection. The strategy’s disadvantage is that if the EUR rises above the futures price, the corporation will be forced to sell the EUR at a lower price than what was agreed upon in the futures contract.
The corporation has AUD exposure and may be required to pay additional AUD if the USD rises in future pricing. The corporation is exposed to AUD receivables and bears the risk of receiving less AUD in the currency market when converting the EUR receivables. To mitigate currency risk, the corporation might employ the exposure netting strategy, which includes balancing one currency’s exposure with another currency’s exposure (Tsai 2018).
References and Bibliography
Deng, Z., 2020. Foreign exchange risk, hedging, and tax?motivated outbound income shifting. Journal of Accounting Research, 58(4), pp.953-987.
https://in.investing.com/currencies/aud-usd
https://in.investing.com/currencies/eur-aud
Iorgulescu, M., 2016, October. Study of single phase induction motor with aluminium versus copper stator winding. In 2016 International Conference on Applied and Theoretical Electricity (ICATE) (pp. 1-5). IEEE.
Möhlmann, A., 2021. Interest rate risk of life insurers: Evidence from accounting data. Financial Management, 50(2), pp.587-612.
Tsai, F.J., 2018. Exposure netting of Foreign exchange rates for Taiwan’s private brand company-GIANT and JHT.
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