Question24 Assume that we have:Spot exchange rate: AUD 1.50 per USDOne-year forward rate: AUD 1.55 per USDRisk-free interest rate in USD: 3% (annualized)Risk-free interest rate in AUD: 5% (annualized) (1) A company has to pay a cost of USD 1 million to its supplier next year. Should the company hedge with a forward contract or do the money market transaction? Present value of cost if using forward = AUD [input] million (1 point)Present value of cost if using money market transaction = AUD [input] million (1point)The company should choose[select: , Forward contract, Indifferent between the two, Money market transaction] (1 point) (2) A company will receive a revenue of USD 1 million from its customer next year. To better hedge the exchange risk, what can the company do (purchase forward contracts or hedge by money market transactions)? Present value of revenue if using forward = AUD [input]million (1 point)Present value of revenue if using money market transaction = AUD [input]million (1 point)The company should choose [select: , Money market transaction, Forward contract, Indifferent between the two] (1 point) Note: (1) Round your answers to 3 decimal places, unless the result is an integer.(2) Keep at least 4 decimal places during your calculations to ensure accurate rounding in the final results.(3) You will get 8 points if all the answers are correct. ResetMaximum marks: 8 Flag question undefined

[select: , Money market transaction, Forward contract, Indifferent between the two]

Question

Question24 Assume that we have:Spot exchange rate: AUD 1.50 per USDOne-year forward rate: AUD 1.55 per USDRisk-free interest rate in USD: 3% (annualized)Risk-free interest rate in AUD: 5% (annualized) (1) A company has to pay a cost of USD 1 million to its supplier next year. Should the company hedge with a forward contract or do the money market transaction? Present value of cost if using forward = AUD [input] million (1 point)Present value of cost if using money market transaction = AUD [input] million (1point)The company should choose[select: , Forward contract, Indifferent between the two, Money market transaction] (1 point) (2) A company will receive a revenue of USD 1 million from its customer next year. To better hedge the exchange risk, what can the company do (purchase forward contracts or hedge by money market transactions)? Present value of revenue if using forward = AUD [input]million (1 point)Present value of revenue if using money market transaction = AUD [input]million (1 point)The company should choose [select: , Money market transaction, Forward contract, Indifferent between the two] (1 point) Note: (1) Round your answers to 3 decimal places, unless the result is an integer.(2) Keep at least 4 decimal places during your calculations to ensure accurate rounding in the final results.(3) You will get 8 points if all the answers are correct. ResetMaximum marks: 8 Flag question undefined [select: , Money market transaction, Forward contract, Indifferent between the two]Multiple dropdown selections

Log in for full answers

We've collected over 50,000 authentic original questions and detailed explanations from around the globe. Log in now and get instant access to the answers!

[select: , Money market transaction, Forward contract, Indifferent between the two]

BlackTom AI · Accepted Answer

We start by restating the scenario and the two sub-parts to hedge or monetize currency risk.
Part 1 concerns a payable of USD 1,000,000 due in one year. We compare a forward hedge to a money market hedge and compute the present value (cost today or locked-in cost) in AUD.
Option analysis for Part 1:
- Forward contract: The cost locked in for paying USD 1,000,000 in one year at a forward rate of AUD 1.55 per USD is 1,000,000 × 1.55 = 1,550,000 AUD. This is a known, fixed future outlay in AUD when using the forward hedge.
- Money market hedge (payable): The standard money market hedge involves borrowing AUD today, converting to USD at the spot rate to invest, and using the USD proceeds to cover the future payoff, while the AUD loan must be repaid with interest. Here, with spot rate 1.50 AUD/USD, to obtain 1,000,000 USD today you would need 1,000,000 × 1.50 = 1,500,000 AUD. You would invest the USD proceeds at 3% for one year, yielding 1,000,000 × (1 + 0.03) = 1,030,000 USD in one year. To repay the AUD loan, you must repay 1,500,000 × (1 + 0.05) = 1,575,000 AUD in one year. The amount you lock in at year-end to settle the USD payable in the money market hedge is 1,575,000 AUD, but the initial funding in AUD today is 1,500,000 AUD. For the purpose of presenting a present-value cost, many calculations report the present value of the year-end AUD obligation as 1,575,000 AUD when evaluating the hedge’s cost burden, while the initial funding outlay is 1,500,000 AUD.
Now, comparing the options:
- Forward: 1,550,000 AUD in year-end terms (fixed). 
- Money market hedge: year-end AUD obligation of 1,575,000 AUD (higher than the forward), with an initial funding today of 1,500,000 AUD.
Conclusion for the decision (Part 1): The forward contract yields a lower year-end AUD cost (1.550m vs 1.575m), so it is financially superior to the money market hedge for a USD 1m payable next year.
Option analysis for Part 2 (revenue of USD 1,000,000 coming in one year):
Now consider a USD receivable and how to hedge to lock in AUD receipts. We compare forward vs money market hedge for a revenue scenario.
- Forward contract (receivable): If you hedge by selling USD forward, you lock in the future AUD amount you will receive from converting USD 1,000,000 at the forward rate of 1.55 AUD/USD. The revenue in AUD would be 1,000,000 × 1.55 = 1,550,000 AUD in one year.
- Money market hedge (receivable): To hedge a USD receivable via a money market approach, you would typically borrow USD today and convert to AUD today at the spot rate, then invest the AUD proceeds to cover the future USD inflow, with the USD loan repaid from the future USD receipt. Using the spot rate of 1.50 AUD/USD and an AUD investment rate of 5%, the process yields: borrow USD today to obtain 1,000,000 × 1.50 = 1,500,000 AUD, invest that AUD at 5% for one year to have 1,500,000 × 1.05 = 1,575,000 AUD in one year. The USD loan to be repaid next year would be 1,000,000 × (1 + 0.03) = 1,030,000 USD, which would need to be converted back to AUD at that year’s rate to settle the loan. In the standard hedge accounting framework, the money market hedge converts to a year-end AUD amount that could be around 1,575,000 AUD for the hedge, depending on the exact conversion mechanics at maturity.
Comparing the two:
- Forward: 1,550,000 AUD in year-end terms.
- Money market hedge: approximately 1,575,000 AUD in year-end terms (assuming the USD loan is repaid and the AUD proceeds are used to settle the USD inflow).
Thus, the forward hedge yields a higher AUD amount than the money market hedge (for a revenue hedge in this setup, the forward result is smaller than the money market result if you’re measuring the amount of AUD received in year-end terms by the hedge). The choice depends on whether you want to lock a specific AUD receipt (forward) or lock in the ability to cover the USD inflow via a funding-then-investment approach (money market). In this numerical setup, the forward provides 1,550,000 AUD, while the money market approach yields about 1,575,000 AUD, so the money market hedge would be preferable if the objective is to maximize AUD receipts.
Summary of decision logic across Parts 1 and 2:
- For part 1 (payable): Forward contract is better (lower cost in AUD) than the money market hedge.
- For part 2 (receivable): Money market hedge tends to give a larger year-end AUD amount in this setup, making it more favorable if the goal is to maximize AUD receipts, though a forward provides a fixed, known amount as well.
Note on rounding and precision: All intermediate figures were kept to three decimals where appropriate, with line-by-line steps showing the cash flows, and the key comparison points highlighted to aid understanding.

Similar Questions

Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should .

Which of the following is cited as a good reason for NOT hedging currency exposures?

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler

Similar Questions

Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should ________ the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should ________.

Which of the following is cited as a good reason for NOT hedging currency exposures?

More Practical Tools for Students Powered by AI Study Helper

Making Your Study Simpler

Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should .