At the end of this module you should be able to:
explain and calculate foreign exchange risk and discuss foreign exchange risk management
explain and calculate commodity price risk and discuss commodity price risk management
determine the key drivers that impact on currencies and commodity price risk management
identify and explain the sources of foreign exchange and commodity price exposures and sensitivities
analyse appropriate risk management strategies that address foreign exchange rate and commodity price exposures
select and apply appropriate hedging instruments to formulate strategies to manage foreign exchange and commodity price exposure.
Gold price exposure?
volatility?
gold price weakens?
Foreign exchange exposure?
functional currency?
AUD strengthens?
competitor position?
Hedging instruments?
forward contract?
futures? options? swaps?
Why only a portion?
level of sensitivity?
hope to achieve greater upside?
production estimates (impacted by weather, industrial action, etc)?
Part A: Foreign exchange risk
Risk of variation in exchange rates and the impact on an organisation - in terms of costs, revenues, assets, liabilities
Currency prices are highly volatile
Australian importers benefit from stronger AUD
Australian exporters benefit from weaker AUD
Hedging instruments
Forex forward (or future) - lock in rate
Forex swap - reduce exposure, provide certainty, or change cash flow timing
Forex option - limit exposure (cap, floor, collar)
A.1. Key elements of foreign exchange
spot price: how exchange rate is determined
two-way prices
forward rates
swaps
options
A.1.1 Spot price
An Australian exporter wishes to sell 100,000 received from a sale and buy AUD. The exchange rate quoted by the bank is AUD/USD 0.7500 - 0.7525. How much will the exporter receive in AUD (in whole dollars)?
75,000
75,250
132,890
133,333
Dealer will buy AUD low/ sell AUD high
Buy AUD 1 for USD 0.75
Sell AUD 1 for USD 0,7525
= USD 100,000 / 07525
= AUD 132,890
A.1.2 Two-way prices
The following information is currently available:
current AUD/NZD spot rate 1.1200
NZ interest rate is 3% p.a.
Australian interest rate is 4% p.a.
What is the AUD/NZD forward rate in 180 days?
1.1092
1.1146
1.1254
forward price is not a spot rate forecast
It: interest rate of the terms currency
Ib: interest rate of the base currency
D: number of days from the spot value date to the forward value date
Y: number of days in the conventional year (e.g. US: 360 days, AU: 365 days)
Arbitrage
buying and selling an asset to make a risk-free gain based on pricing inefficiency
Assume the following:
AUD/EUR spot rate 0.5000
Australian interest rate 5.5%
Eurozone interest rate 3.0%
FX Dealer offers 1-year AUD/EUR forward rate of 0.4750 (based on a forecast)
Implicit exchange rate: EUR 10,300 / AUD 21,100 = 0.4882
A.1.4 Swaps
Swaps and timing mismatches
buy (sell) and sell (buy) and amount of currency on a date
exact reverse transaction on a future date
manages timing mismatches with FX cash flows
A.1.5 Options
Put
buy: right to sell at strike price
sell: obligation to buy at strike price
Call
buy: right to buy at strike price
sell: obligation to sell at strike price
FX put option - example
Fantell Ltd is an importer of manufacturing equipment. It has a large order that requires payment of USD $6,000,000 to its Japanese supplier in 3 months' time.
The current exchange rate is AUD/USD 0.8000 and Fantell Ltd wants to protect against a falling AUD. It decides to buy an AUD put option with a strike rate of AUD/USD 0.79000, for a premium of 0.0150.
Assuming the exchange rate in 3 months time is AUD/USD 0.7925, what is the AUD required by Fantell to settle the USD payment?
A.2. Foreign exchange risk management
FRM framework: https://angelaseoyeonlim.wixsite.com/angela/post/cpa-frm-module-5-interest-rate-risk-management-knowledgequity
A.2.1 Set the core criteria
Functional currency - different to reporting currency
Business drivers - profit targets, returns, cash flows, NPVs
Organisation objectives - strategic plans, opportunities and threats
A.2.2 Identify exposures and sensitivities
Committed - contracted (e.g. sales, purchases, interest payments)
Uncomitted - forecast transactions
Capital - assets, borrowings
Operating - revenues, costs, debt servicing
Primary - business operations
Secondary - result of hedging exposures
Transaction - paying or receiving foreign currency (Opex, Capex, Revenues)
Translation - Asset or liability in a foreign currency, Exposure impacts Balance Sheet
Competitive - competitor has a different (lower) cost base sourcing overseas
Apparent v Actual exposures
Internal offsets - e.g. exporting Product A- importing Product B
Embedded options - e.g. repricing clause in a purchase agreement
Timing mismatches - e.g. receipt of USD 5,000 today; payment of USD 5,000 in 3 months
Commercial adjustments - e.g. pass on costs to customer?
A.2.3 Appraise risks and set strategies
A.2.4 Manage risks
Foreign exchange risk
Forward exchange contracts
MNO Ltd is an Australian organisation that imports machinery from New Zealand. In 180 days, MNO Ltd is due to pay NZD 1,500,000 to a supplier.
The AUD/NZD spot rate is 1.1000. The AUD/NZD 180-day forward rate is 1.1027. An available AUD/NZD 6-month put option strike rate is 1.1100.
What is the AUD amount that MNO Ltd could lock in with a forward exchange contract?
AUD 1,351,351
AUD 1,360,297
AUD 1,363,636
AUD 1,654,050
Here, we can discard the reference to the spot rate and the available put option strike rate.
The AUD/NZD 180-day forward rate of 1.1027 would have been calculated using the forward rate formula. [The AUD is the base currency and the NZD is the terms currency.]
We need to apply this forward rate to the NZD 1,500,000 purchase price.
MNO Ltd can lock in AUD $1,360,297 (i.e. NZD 1,500,000 / 1.1027).
Forward exchange contracts
agreement with a bank
future dated
specified amount of currency
specified exchange rate
- no upfront costs
- calculated forward rate, not a forecast
- locked-in, no benefit from favourable movements
Forward exchange options
An Australian importer has a contract to purchase goods costing USD 50,000 in three months' time.
The current spot rate is AUD/USD 0.7500. To reduce exposure, an AUD/USD put option is purchased with a strike price of 0.7250 for a premium of 0.0050. If the exchange rate at expiration of the option is AUD/USD 0.7100, what is the importer's total cost in AUD?
AUD 66,667
AUD 68,965
AUD 69,444
AUD 70,422
(1) Exercise the put option as spot rate < floor rate at expiry
i.e. AUD/USD 0.7100 < AUD/USD 0.7250
(2) Adjust the effective exchange rate for the premium of 0.0050
i.e. AUD/USD 0.7250 - 0.0050 = AUD/USD 0.7200
(3) Sell AUD and buy USD at an 'effective rate' of AUD/USD 0.7200
= USD 50,000 / 0.7200
= AUD 69,444 [= 'total cost', including the premium]
FX options - usage
AUD put option = foreign currency call option
right to sell AUD and buy foreign currency
importer (limits losses on falling AUD, but retains upside)
AUD call option = foreign currency put option
right to buy AUD and sell foreign currency
exporter (limits losses on rising AUD, but retains upside)
Collar option
combination depends on requirements
nil or small premium (limits losses and limits upside)
A.2.4 Accounting and controls
Part B: Commodity price risk
Types of commodities
softs (grain, wheat, corn, etc)
precious metals (gold, etc)
base metals
energy
livestock
bulk (iron ore, etc)
Commodity basics
basic level goods (e.g. agricultural crops, metals, energy, livestock)
physical substances
quality unlikely to vary - but grades exist
Quiz. Contango and backwardation
The current exchange rate is AUD/USD 0.7500, and the 6-month forward exchange rate is AUD/USD 0.7700. The current crude oil spot price is USD 54.00 per barrel, and the 6-month crude oil forward price is USD 52.00 per barrel.
Which of the following correctly describes the crude oil market?
The crude oil market is in backwardation
In USD, the crude oil market is in contango
In AUD, the crude oil market is in contango
The crude oil price is going to fall in the next 6 months
USD:
Spot 54.00 > Forward 52.00
AUD:
Spot 54.00 / 0.7500 = AUD 72.00
>
Forward 52.00 / 0.7700 = AUD 67.53
Contango: forward price higher than spot price (price in future > today's price)
Backwardations: forward price lower than spot price
Quiz. Gold forward rate
Assume the following information:
Gold spot price is AUD 1,500 per ounce
Australian 12-month interest rate is 3%
12-month gold lease rate is 1%
Bank's profit margin is 0.50%
What is the effective gold forward rate in AUD?
AUD 1,500.00
AUD 1,522.50
AUD 1,537.50
Bank borrows an ounce of gold from the central bank and then raises AUD 1,500 per ounce by selling the gold on the spot market
Bank earns interest at 3.0%, offset by paying gold lease fees of 1.0% and taking a margin of 0.5%... the net benefit being 1.5% (0.030 - 0.015 = 0.015)
The effective gold forward rate is therefore AUD 1,500 x 1.015 = AUD 1,522.50
211120
Comments