FOREX HEDGE

It is now 31st December 2016. Durran Inc. is a US-based speciality chemicals company, with its head-office located in the North Shore area of Staten Island NY, and with production units in Mexico, India and Malaysia, as well as in up-state New York. JohorChem Berhad is the company’s Malaysia agrichemical operation and this division exports most of its output to a range of countries in South-East Asia and the Pacific-rim. Because of the highly competitive market for agrichemicals, these export trades are normally denominated in the customers own currency but in the past, JohorChem has not bothered to hedge its foreign exchange risk exposures and instead has relied on the belief that having a well-diversified portfolio of currency exposures will itself operate as an effective hedge. However, the division has suffered significant foreign exchange losses in recent months and the company’s newly appointed CFO is looking to change this policy and to hedge the division’s export trades against the US dollar, (US$), the parent company’s home currency. JohorChem has most recently signed a contract for the sale of a quantity of bovine somatotropin to the Australian Government, to help expand the Australian dairy industry, for a negotiated price of US$2,130,000. Given the current spot rate between the US and Australian dollars, JohorChem has agreed to invoice the Australian government for 2,800,000 Australian dollars, (A$), payable on 30th June 2017. JohorChem’s bank – AmBank – has informed them that the current spot exchange rate between the US and Australian dollars is US$0.7610 = A$1 and that the 6-month forward rate is US$0.7536. Australian dollar 6-month money market interest rates are currently 4% per year on loans and 3.5% per year on deposits. The equivalent annual US$ rates are 2.5 % and 2%, respectively. AmBank has indicated that they would be willing to enter into either a 6-month European call or put option on A$2.8 million, at an exercise price of A$1.3158/US$, for a premium of US$29,000 on the call and US$54,000 on the put. US$/A$ traded currency options are available on the North American NASDAQ market with the following premiums: Strike price Calls Puts US$=A$1 March June March June 0.750 1.42 1.55 1.13 1.35 0.755 1.31 1.47 1.26 1.49 0.760 1.19 1.39 1.42 1.58 0.765 1.02 1.14 1.59 1.75 0.770 0.94 1.02 1.67 1.92 Contract size: A$10,000. Premium quotes: 1 tick equals US$100 (i.e. 1.12 = US$112) Required: a) You are currently working as an executive assistant to the new CFO of JohorChem and she has asked you to prepare a report comparing the expected outcomes from hedging the cash proceeds of this contract using: i) a forward market hedge. ii) a money market hedge. Compare the outcome of these two hedges. Recommend, with reasons, which hedging method would be preferable. b) Add an appendix to your report that briefly discusses the advantages and disadvantages of using currency options to hedge the company’s foreign exchange risk exposure on the Australian contract, rather than forward or money market hedges. c) Demonstrate how you would undertake a traded option hedge in respect of JohorChem’s A$2.8 million currency exposure. d) Contrast the outcome of the OTC option hedge with the forward market hedge if, on 30th June 2017, the actual spot rate was US$0.7480 = A$1. e) You are now told that the company’s contract with the Australian government is contingent on satisfactory Australian government tests on the purity of the bovine somatotropin that would be supplied by JohorChem. These test results will not be available until the end of February 2017. Explain how a deal-contingent currency forward hedge might work for JohorChem and contrast its use to hedging via an OTC option. f) In order to help the company’s cash flow, JohorChem finally decide to use a money market hedge in respect to the Australian contract. However, the Australian government now announce that they would consider foregoing the 6-month credit period and would pay immediately, in exchange for a discount on the agreed price of A$2,800,000. What is the maximum discount that JohorChem should offer? Need solution to this. Thank You