Exchange Risks in Micro-, and Macro-Economics - Case Study Example

Case Study: Micro & Macro-Economics-Exchange Risks Unit (a) It is completely justifiable that the company is using a European style option. Since the Australian company is receiving 15 million USD for the goods, they only concern they have is that the USD does depreciate in value before the transaction date. Assuming no expenses, at the current spot rate of 1AUD=0.9315 USD, 15 million USD is equal to 16.103 million AUD in 9th September (GAVINO 2014). A one month forward mid-rate gives us the exchange of 1AUD=0.9296, which means that 15million USD= 16.136 MILLION AUD. This gives the Australian company an arbitrage opportunity. They can gain from a one month forward contract and essentially make a profit of (16.136-16.103) = 0.033million AUD. (b) Designing a suitable hedge for the 31st October 2014 consignment: Exchange rate: 0.9315 Australian interest rate: 2.87% US interest rate: 0.21% CME September Future: 0.9286 CME October 0.9250 put option: 0.0780 CME October 0.9450 put option: 0.2290 The 0.9450 put option is at a strike price that is not close to making a profit. It is obviously higher than the 1 month forward rate provided. The Australian firm is only worried that the Australian dollar can depreciate against the US dollar on the day of transaction. If 0.9250 is selected, then a higher premium will be payable to the clearing house. The clearing house protects the counterparties against the potential loss in value of the currencies used. Assuming the firm takes the strike at 0.9250, then the premium (insurance) for every option will be (0.0780*15million) = 1.17 million USD, so in 31st October the firm gets (15/0.9250)=16.22 million AUD. Designing a suitable hedge for the 31st January 2015 consignment Exchange rate: 0.9257 (mid-rate 3 month forward) Australian interest rate: 2.98% US interest rate: 0.29% CME December Future: 0.9227 CME November 0.9250 put option: 0.1140 CME November 0.9450 put option: 0.2460 The Australian firm buys the put option at the 3 month forward. 15 million USD is equal to 15/0.9257 = 16.203million USD. The premium of the put option is 15million*0.114 = 1.71million USD. If the exchange goes above the strike price then the firm exercises the option and makes profit of (0.2486-0.114)*15=1.98 mill USD. Designing a suitable hedge for the 30st April 2015 consignment Exchange rate: 0.9198 (mid-rate 6 month forward) Australian interest rate: 3.09% US interest rate: 0.45% CME March Future: 0.9169 CME March 0.9250 call option: 0.1500 CME March 0.9450 Call option: 0.0740 Using call option, the firm can also make a profit in case the AUD depreciates against the USD. That is, (0.15-0.0740)*15=1.14 million USD or 1.14/0.945=1.206 million AUD. Designing a suitable hedge for the 31st July 2015 consignment Exchange rate: 0.9198 (mid-rate 6 month forward) Australian interest rate: 2.98% US interest rate: 0.29% CME June Future: 0.9113 CME June 0.9250 put option: 0.3190 CME June 0.9450 put option: 0.4420 Using a 6 month forward from January, the exchange mid-rate is 0.9198, this is equal to 15/0.9198=16.31 mil AUD. But the June future contract can offer an exchange of 15/0.9113=16.4 million. (c) The effectiveness of hedging is that it maintains the value of the $15 million invoice despite any fluctuation in the exchange rate between the two countries. If the invoice payment not hedged, then the 15 million USD can be changed using 31st October spot rate. In case the Australian dollar depreciates against the US dollar, then the firm makes a loss i.e. (16.22-16.13) =0.09mil AUD. The 0.925 option gives us 16.22mil AUD and the one month forward mid-rate of 0.9206 gives us 16.13mil AUD. Which is lower than the former (HICKS 2000). (d) Calculating loss or profit: (i) Action Date Spot CME Premium Basis 09 September 14 31st October 14 31st January 15 Long AUD/Short USD 0.9257 Long AUD/Short USD 0.9450 Loss -0.0193 Sep. Futures Dec. Futures Profit 0.9286 0.9227 0.0059 Basis Change = 0.0059-0.0193 =-0.0134 The basis change is negative, which means that the net profit is negative, implying that the former hedge strategy was better. (ii) Action Date Spot CME Premium Basis 09 September 14 31st January 15 30th April 15 Short AUD/Short USD 0.9197 Short AUD/Short USD 0.9250 Loss - 0.0053 Sep. Futures March. Futures Profit 0.9286 0.9169 0.0117 Basis Change = 0.0117-0.0053 =0.0064 A positive basis change show that the above illustrated combination will be effective to hedge the currency risk. Action Date Spot CME Premium Basis 09 September 14 30st April 15 31st July 15 Short AUD/Short USD 0.9089 Long AUD/Short USD 0.9450 Loss - 0.03615 Sep. Futures Dec. Futures Profit 0.9286 0.9113 0.0113 Basis Change = 0.0117-0.0053 =-0.01885 (iii) The basis change is negative hence the hedge strategy used in (b) is preferable to the one above. (e) One major amendment made to OTC derivatives trading is; every standardized OTC derivative agreements should be traded on an electronic trading platform or over an exchange. Moreover, OTC derivatives should be cleared through a clearing house by the beginning of January 2013. Contracts that are cleared through a clearing house should have a higher capital allocation in order to manage the high risk involved. Research conducted by the FSB (financial stability board) showed that the 2008-2009 financial crisis exposed weakness in the OTC derivatives market that had greatly contributed to the build-up of systematic risks. Some of the major changes made are: Central Clearing - In order to achieve the G-20 commitment to enhance financial solvency, a clearing house should be set up to standardize the counterparty risk. The advantage of this is that it addresses essential clearing requirements; stable risk management framework for the outstanding non-centrally cleared markets. Having a global perspective of markets integration is essential for controlling systematic risks that may arise through OTC derivative trading (FINANCIAL STABILITY BOARD 2010).The recommendations require that trade repository data be uniform and comprehensive across all exchanges. Electronic trading platform/ Exchange – The introduction of algorithmic trading has enabled OTC derivative to be traded on electronic platforms. Integrated electronic platforms are easier to update in microseconds which essentially reduces price anomalies and systematic risks. Standardization - The ratio of standardized financial instruments in the market should increase significantly in order to enhance changes in central clearing on organized platforms. This amendment will help to improve market transparency and control systematic risks. By increasing standardization of OTC derivatives and introducing incentives and regulations, an efficient risk management framework is achieved. In the above situation, using over the counter derivatives would subject the firm to limited data, and the lack of a clearing house increases the systematic risk (market + counterpart risk (US firm)). The Australian firm may make a significant profit or loss if they use OTC derivatives for hedging. However with exchange traded hedging the Australian firm is guaranteed of maintaining the value of the invoice by the clearing house since the terms in the contract are standardized. References STEPHENS, J. J. (2003). Managing Currency Risk Using Financial Derivatives. Chichester, John Wiley & Sons. http://public.eblib.com/choice/publicfullrecord.aspx?p=152679userid=^u. HULL, J., & HULL, J. (1997). Options, futures, and other derivatives. Upper Saddle River, NJ, Prentice Hall. HICKS, A. (2000). Managing currency risk using foreign exchange options. Boca Raton, [Fla.], CRC Press. BATTERMANN, H. L., & BROLL, U. (1997). The use of derivatives markets for hedging currency risks. München, Volkswirtschaftliche Fak., Ludwig-Maximilians-Univ. BOS, C. S., MAHIEU, R. J., & DIJK, H. K. V. (2001). Daily exchange rate behaviour and hedging of currency risk. Amsterdam, Tinbergen Institute. PAPAIOANNOU, M., & ROCHON, C. (2006). Exchange rate risk measurement and management issues and approaches for firms. [Washington, D.C.], International Monetary Fund. http://site.ebrary.com/id/10380728. CUSATIS, P., & THOMAS, M. (2005). Hedging Instruments and Risk Management. London, McGraw-Hill Education - Europe. CHISHOLM, A. M. (2014). Derivatives demystified a step-by-step guide to forwards, futures, swaps and options. Hoboken, N.J., Wiley. http://rbdigital.oneclickdigital.com. TAYLOR, F. (2007). Mastering derivatives markets: a step-by-step guide to the products, applications and risks. Harlow, England, Financial Times/Prentice Hall. GREGORY, J. (2014). Central counterparties: mandatory clearing and bilateral margin requirements for OTC derivatives. ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT. (2011). Regulatory Reform of OTC Derivatives and Its Implications for Sovereign Debt Management Practices Report by the OECD Ad Hoc Expert Group on OTC Derivatives - Regulations and Implications for Sovereign Debt Management Practices. Paris, OECD Publishing. http://dx.doi.org/10.1787/5k9gz2n0sgq2-en. CHOI, J. J., & PAPAIOANNOU, M. G. (2009). Credit, currency, or derivatives: instruments of global financial stability or crisis? Bingley, Emerald. GAVINO, N. (2014). Reform of over-the-counter derivatives markets: international efforts. http://alltitles.ebrary.com/Doc?id=10890079. FINANCIAL STABILITY BOARD. (2010). Implementing OTC derivatives market reforms. [Basel, Switzerland], Financial Stability Board. http://www.financialstabilityboard.org/publications/r%5F101025.pdf. PEERY, G. F. (2012). The post-reform guide to derivatives and futures. Hoboken, N.J., John Wiley & Sons. Read More