Managing Exchange Rate Risk

International Finance

Exchange Rate Movements for the U.S. And Australian Dollar and Hedging

On the 9th June 2013 the initial $90,000 investment was worth $94,724.9. Knowing that the exchange rate on that date was AU $1.0525 to the U.S. dollar, meaning that U.S. $1 would purchase $1.0525, it is possible to determine that the total investment had purchased AU $99,697.96 (Oanda, 2013).

On the 7th June the exchange rate has changed to $1.1019, with the given fund value of AU $99,697.96, the change leaves a fund that is worth U.S. $90,478.23 (Oanda, 2013).

It is possible to look at the exchange rate movements over a period of time taking data from Oanda (2013). The tables below present that value for the last week, the last week of 2013 and the last week of 2011.

Part A

Table 1; Exchange rates for 1st - 7th July 2013

Exchange rate

7th July 2013

$1.1019

6th July 2013

$1.0964

5th July 2013

$1.0957

4th July 2013

$1.0991

3rd July 2013

$1.0884

2nd July 2013

$1.0882

1st July 2013

$1.0934

Part B

Table 2; Exchange rate 25th Dec 2012-31st Dec 2012

Exchange rate

31st Dec 2012

$0.9640

30th Dec 2012

$0.9640

29th Dec 2012

$0.9634

28th Dec 2012

$0.9643

27th Dec 2012

$0.9649

26th Dec 2012

$0.9645

25th Dec 2012

$0.9621

Part C

Table 3; Exchange rate 25th Dec 2011-31st Dec 2011

Exchange rate

31st Dec 2011

$0.9827

30th Dec 2011

$0.9909

29th Dec 2011

$0.9852

28th Dec 2011

$0.9844

27th Dec 2011

$0.9838

26th Dec 2011

$0.9847

25th Dec 2011

$0.9854

Question 3

If a U.S. firm is doing business with an Australian firm and will need to use Australian dollars, there is an open position where a firm will need to buy a commodity (in this case AU $) at some point in the future, but the price could change before that purchase is made. A tool often used by firms to minimise that risk is heading. Hedging involves the purchase of a contract that will fix the price of the commodity in advance. The contract will use derivatives; it may be the use of a future which binds the firm to the agreed price for the currency, with the firm obliged to by AU dollars at the agreed price on the agreed date. The price which is set for the commodity will reflect the markets expectations. If the spot price changes due to the Australian dollar appreciating against the U.S. dollar, the firm will gain, as the agreement will have been made while the Australian dollar is at a lower price. However, if the Australian dollar depreciates against the U.S. dollar, the firm may not benefit from hedging, as the spot price would have been lower than the contract price. To overcome the potential to loose out, a more common approach to hedging is the use of options; these are contracts where the firm purchasing the contract has the right to buy the currency at an agreed price o the agreed date, but they are not bound to that purchase; they are buying the option to make the purchase at the agreed price.

To determine whether or not the firm should hedge the firm needs to assess the current risk and the way in which hedging may have the potential to reduce the risk. It is important to remember that when hedging a firm is not eliminating risk, it is changing one type of risk for another. The firm needs to assess which type of risk is most acceptable. If the firm uses a hedging strategy where options rather than futures are purchases the firm may avoid the risk associated with being tied into an exchange rate that is more costly than the sport rate. However, there is still risk, as the firm will be paying for the contract and the over heads associated with hedging, including the addition accounting costs even if the contract is not used. Therefore, the firm will need to decide if the exchange rate risk remaining un-hedged is an acceptable risk (Giddy, 2002). If the risk is acceptable, for example it is a proportionality small contract, the firm may decide that hedging is not necessary. The firm may also look at the potential they will need to use an option; considering if the firm believes the exchange rate will move, and how it will move (Giddy, 2002).