An Australian farmer has just sold a shipment of live sheep worth KWD100 000 to Kuwait, with the payment due in three months. The company wishes to hedge this exposure, since the Kuwaiti dinar is expected to depreciate against the Australian dollar in the next three months. Australian banks are unwilling to offer forward contracts on the Kuwaiti currency. However, Kuwaiti banks offer forward contracts to trade the currency against the US dollar. The following information is available:
Current spot rate (AUD/KWD) 5.46
Expected spot rate (AUD/KWD) 5.20
Current spot rate (KWD/USD) 0.340
Expected spot rate (KWD/USD) 0.324
Three‑month forward rate (KWD/USD) 0.322
Current spot rate (AUD/USD) 1.8564
Expected spot rate (AUD/USD) 1.6848
(a) Explain how cross hedging can be implemented.
(b) Supposing that all expectations are fulfilled, calculate the Australian dollar value of the KWD receivables under the hedge and no-hedge decisions.
(c) Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?
(d) Should a firm hedge? Why or why not?
Question 2 – Currency Swap
Trident is a multinational corporation that has operations in several countries. Although Trident is based in the US and its profits are reported in USD, its revenues are denominated in various currencies including the AUD. Recently, Trident took out a 3 year USD loan at a fixed interest rate of 3.5% per annum. Since Trident has AUD revenues, it has decided to enter in a three year swap to receive USD and pay AUD. The quoted currency swap rate is 5.6% on the AUD loan. The notional amount of the swap is USD 10 million with the USD/AUD exchange rate of 0.77.
- Calculate the USD loan interest payments
- Calculate the AUD principal and interest payments under the swap agreement
- Draw the following time lines with their respective values
USD Loan payments _______________________________________________
SWAP Receive USD _______________________________________________
SWAP Pay AUD _______________________________________________
- One year into the swap agreement, Trident’s operations in Australia have become unprofitable and it has decided to withdraw from the Australian market. Consequently Trident has to unwind the swap as it no longer has the AUD revenue to service the AUD swap payments. At that time the two year fixed rate on the USD loan is 3.2% per annum and the two year fixed rate on the AUD loan is 5.5% per annum. The spot rate is USD/AUD 0.75.
- Calculate the present value of the remaining USD swap receipts.
- Calculate the present value of the remaining AUD swap payments.
- Calculate the present value of the swap. Hint: the present value of the swap is the difference between the present value of the payments and the present value of the cash flows received discounted at interest rates applicable to each currency.
- For the swap to be discharged, identify who pays whom what?
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