Hedging Exchange Rate Risk at Afterpay Assignment Sample

Optimal Capacity Investment

Table of Contents

1.0 Exchange rate forecast.

2.0 Sensitivity analysis.

3.0 Scenario analysis.

4.0 Recommendations.

1.0 Exchange Rate Forecast

If you think that bankers only need to focus on currency and exchange rates, think again. Many businesses face currency risks, whether they know it or not. Exchange rate risk is again on the agenda of companies that have clients, suppliers or products in other countries, with the recent wild fluctuations in global currencies.

March and April carry drastic currency market swings with the outbreak of the coronavirus. The global economy has been broken by stricter laws to stem the tide, leading to a drop in oil prices and stock markets. The market is searching for safe havens, heading towards the US dollar, the Japanese yen and the Swiss franc (Dyhrberg, 2016).

The key lesson is that if you run an income generating business overseas or have expenses in another country, you are likely to risk money. Events beyond your control can wipe out your income and increase your expenses (Engel & Matsumoto, 2009).

Graph below represents past data of exchange rates AUD/USD from 1991 to 2020, on the bases of this data future value for next six months would be extracted using ARIM model.

Above table shows exchange rate movements from 1991 to 2020, it remained between 0.5 minimum in 2002 and 1.1 maximum near 2012 and 2013.

Forecasting values and graphs has been extracted by using ARIMA model in Eview, it’s like to decrease exchange rate AUD to USD for next six month on the basis of past data sample used from 1991 to Oct 2020.

Above represents that value of exchange rate could remain up to 0.6145 till month 8 (Aug 2020), here M3 represents 2010 and so on till M10 as month of march 2021. Forecast represents that there would be reduction in prices in future.

2.0 Sensitivity Analysis

The numerous maritime economic developments have, of course, taken place at the same time. Interest rates, different GDP growth rates, shifting trade flows, and so on will vary in different countries. In a brief amount of time (days, weeks), the convergence of all these variables makes it difficult to forecast exchange rates. Such pillars are going at the same time in various directions. Economists therefore claim that the exchange rate shifts in a "random way," meaning that today's exchange rate is the best estimate for tomorrow's exchange rate. The value-and-decline issues are the same (Erkoc, Wang, & Ahmed, 2018).

The influence of certain macroeconomic fundamentals on exchange rates is more evident in the medium term (months, several years). For example, if an economy is increasing quickly, the currency will be priced because the country absorbs foreign capital that stimulates local demand for money.

In comparison, in the long run (years, decades), macroeconomic dynamics do not play a part. Economic growth rates, interest rates, and international exchange and investment flows have been stabilized at "average" rates for a long time. Again, the only determinant of the exchange rate is the money supply growth rate. Currency inflation will occur in countries that print money quicker. In fact, a raise in the money supply would be proportional to the amount of deflation. Remember that a currency's value is a currency's value (Black, 2018).

Sensitivity analysis has been conducted on the basis of 10% increase in exchange rate and 10% decrease in exchange rate from AUD to USD.

Observing excel output below, it has been seen that increasing exchange rate has been increased AUD profit from 248.8 to 273.7 and decreasing exchange rate has reduced profit of the firm from 248.8 to 224, same has been happened with US dollar amount.

Net transaction margin has been increased with increased in dollar rate and decreased with decrease in exchange rate. Base rate has been considered from 10 Oct 2020 for all calculations.

3.0 Scenario Analysis

As option is put option hedging, so it’s only to sold at stronger USD, under forward contract transaction might be taken at higher or lower rate, in case of 75% forward and 25% option, rate of forward has been considered 75% of total weightage and 25% of option rate for total weightage and so on for other consideration.

Forecasted sale has been considered 222 million as per growth in sale based on last six months for next six months. Impact has been calculated by multiplying exchange rate to 222 million profit and subtracted baseline 100 million from 175.63 (222*0.7911) to get 60.1526.

4.0 Recommendations on Hedging Exchange Rate Risk at Afterpay

Higher profit could be earned under unhedged condition of higher market rate of dollar and same on 100% forward contract of exchange rate at higher rates. Remaining same rates would provide an adequate profit of 45.92 million and reducing rates would reduce profit as well. Under changing percentage of forward and option more part of forward price would be beneficial.

 References for Hedging Exchange Rate Risk at Afterpay

Black, M. (2018). Hedging Against US Chinese Currency Fluctuation. Journal of Applied Business and Economics, 20(9).

Dyhrberg, A. H. (2016). Hedging capabilities of bitcoin. Is it the virtual gold? Finance Research Letters, 16, 139-144.

Engel, C., & Matsumoto, A. (2009). The international diversification puzzle when goods prices are sticky: it's really about exchange-rate hedging, not equity portfolios. American economic Journal: macroeconomics, 1(2), 155-188.

Erkoc, M., Wang, H., & Ahmed, A. (2018). Optimal Capacity Investment, and Pricing Across International Markets Under Exchange Rate Uncertainty and Duopoly Competition. Available at SSRN 3152729.

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