Foreign Exchange Markets

Foreign Exchange Markets
(FIN341)

Assignment

Total marks: 100

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Instructions to students

•    This assignment covers Topics 1 to 6 and accounts for 40% of your final grade.

•    There are six (6) questions in this assignment. You should answer all questions.

•    The overall word limit for the assignment is 2800 words. Marks will only be awarded for answers up to the word limit (plus 10%) for each question. Any material written after this will not be counted towards your mark for that question. Headings, quotes and references within the body of the answer are included in the word count. Numerical tables, calculations, and reference lists are not included. For more information on word counts and their rationale, go to Assessment à Assignment àGeneral assessment information.

•    Refer to the Criteria-based Marking Guide for guidelines on what is expected for each question.

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Criteria-based Marking Guide

The Criteria-based Marking Guide provided at the end of each question is designed to assist students to understand what is expected of them in each question and to let them know how their performance will be judged. It provides advice about the criteria used in the marking of the question and what discriminates between an excellent, satisfactory and unsatisfactory answer.

Case study: HilltopEstate Wines Pty Ltd

Hilltop Estate Wines Pty Ltd is a family run winery located in the Yarra Valley, Victoria. Since inception, it has only sold to the domestic market. However, with the recent handing over of the reigns to the next generation, Hilltop has decided to begin to exporting wine to the US market — with Australian wines currently enjoying strong demand.

As Hilltop’s treasurer, Tianais responsible for managing the company’s financial exposures, cash flows and implementation of treasury policy.

The following is an extract from the Hilltop’s treasury policy manual:

‘… Unless otherwise formally advised by the chairman of the board, all foreign exchange exposures must be fully hedged to the foreign currency amount upon confirmation, as determined by the purchase order. Exposures can be managed either through the use of forward exchange contracts or by the purchase of a suitable FX options contract…

Section 5: Any foreign exchange or money market transaction must be undertaken for the sole purpose of hedging corporate exposures. Cross platform and synthetic transactions are permitted provided their sole purpose is to improve pricing efficiency…’

Today is 1stSeptember 2016.

Sales

All sales are denominated in USD with invoices due three calendar months after the shipment date.

Tiana hascompiled the following confirmed purchase orders:

Expected shipping date Invoice amount
5 October 2016 USD1,900,000
6 November2016 USD1,400,000
24 November2016 USD1,655,090
5 June 2017 USD2,350,000

You obtain the following pricing information from your bankers:

  AAA Bank BBB Bank
Spot: AUD/USD 0.7116/20 0.7118/22

AUD/USD forward prices (straight months):

Overnight 0.5/0.4 0.5/0.3
tom/next 1.55/1.54 1.55/1.54
3-month 31/30 30/29
4-month 43/40 44/42
5-month 56/54 56/55
6-month 67/66 64/63
12-month 124/118 123/118

New equipment

Recent declines in the AUD/USD exchange rate have brought opportunity to Hilltop in the form of strong interest in their premium brand. Vines planted several years ago are beginning to yield excellent crops. This, coupled with a strong 2015/16 growing season have resulted in Tiana estimating that the throughput during the 2016 vintage will be approximately 40% higher than the previous year. However, the processing equipment currently on hand will not be able to adequately handle the greater volume. Therefore, the family has decided to expand production facilities to cater for an expected increase in grape supply. As such, they have committed to the purchase of two new fermentation tanks.This item will be sourced from the United States and will cost USD2,700,000. This purchase will be fully funded by new debt. A final decision on the exact source of funds is yet to be made, so the Tiana has recommended that this exposure remain unhedged for the time being — something the rest of the family has agreed to.

The company has also hired the services of a specialist consultant and installation company for the new tank. Strangely enough, this team is based in Japan and has quoted a total fee of JPY 4,100,000 payable intwo equal instalments on 5thSeptember 2016 and 5th December 2016. These fees have been approved for payment.

Credit and borrowings

The company has a sound balance sheet and holds an AA credit rating. Their existing debt is comprised of a (fully drawn) line of credit from Bendigo Bank.

Recently, several major American banks have been offering attractively priced credit facilities to Hilltop due to Australia’s good economic standing and strong growth forecasts for the industry. They have offered funds at LIBOR (flat). By comparison, Bendigo Bank will only offer a new credit facility for this project at a rate of BBSW + 1.00%.

The economy and currency outlook

The Reserve Bank of Australia (RBA) has hinted that interest rates will remain stable or even rise in the face of an emerging price bubble in the property market.On the other hand, the market seems a little confused regarding the future actions of the US Federal Reserve, but the market consensusis that US rates will ‘stay on hold’ for the foreseeable future. Hilltop’s bankers have provided a forecast that the AUD/USD rate will steadily strengthen to around AUD/USD 0.7700by mid-2017 — a view thatTiana also adopts in her strategic planning.

Question 1     (15 marks | Word limit: 1000 words)

(a)       List and explainfour (4) factors that impact on the future level of the Australian dollar.Please provide suitable support for arguments. (4 marks)

(b)          Explain the concept of PPP (purchasing power parity) as a method of predicting the future value of a currency. Describe one significant weakness in its use.(2 marks)

(c)       Describe the likely impact on the Australian dollar (AUD) of the following announcements:

(i)        The ABS releases inflation and growth data that is considerably above market expectations.(1 mark)

(ii)       The Australian government approves an application by the Chinese government to purchase all Australian national rail infrastructure.(1 mark)

(iii)      Statistics indicate global economic growth showing clear signs of improvement, supported by IMF forecasts of a doubling of growth over the coming years.(1 mark)

(iv)             The perfect storm occurs for the Australian grain industry — a bumper local wheat crop coupled with drought conditions across the major wheat-belts in the United States.(1 mark)

(v)       Australian commercial banks announce that they will selectively targetcommercial borrowers with higher interest costs selectively on property due to the existence of a commercial property bubble in Australia.The bubble has been driven mainly by domestic demand funded by domestic borrowings. (1 mark)

(d)          The Australian federal government is about to embark on an extensive public borrowing program to fund the NBN rollout. Explain the likely impact of this program on the AUD if it is funded entirely:

(i)        onshore(2 marks)

(ii)       offshore.(2 marks)

Criteria-based marking guide for Question 1

  Excellent
(Mark range: 11.5–15 marks)
Satisfactory
(Mark range: 7.5–11 marks)
Unsatisfactory
(Mark range: 0–7 marks)
(a) Ÿ  Correct and detailed explanation of the four (4) factors

Ÿ  Thorough and detailed link between the explanation and outcomes

Ÿ  Correct but basic explanation of the four (4) factors

Ÿ  Adequate link between the explanation and outcomes

Ÿ  Incorrect or no explanation of the four (4) factors

Ÿ  Unclear or no link between the explanation and outcomes

(b) Ÿ  PPP correctly detailed and explained

Ÿ  Major PPP weakness well cited and explained

Ÿ  PPP adequately detailed and explained

Ÿ  Major PPP weakness adequately cited and explained

Ÿ  PPP no explained or incorrectly detailed and explained

Ÿ  Major PPP weakness not adequately cited or explained

(c) Ÿ  Correct and detailed description of the impact of points (i)–(v) on the Australian dollar Ÿ  Correct basic description of the impact of points (i)–(v) on the Australian dollar Ÿ  Incorrect, unclear or no description of the impact of any of points (i)–(v) on the Australian dollar
(d) Ÿ  Correct and detailed explanation of the impact of points (i)–(ii) on the Australian dollar Ÿ  Correct basic explanation of the impact of points (i)–(ii) on the Australian dollar Ÿ  Incorrect, unclear or no explanation of the impact of either of points (i)–(ii) on the Australian dollar

Insert your answers to Question 1(a)–(d) below this line

 

 

End of answers to Question 1(a)–(d)

 

Question 2     (15 marks | Word limit: 400 words)

You begin the process of making the first part-payment of Japanese yen (JPY) to the contractor.

You obtain the following spot prices:

  AUD/USD USD/JPY
Bank DDD 0.7113/17 112.53/58
Bank EEE 0.7111/15 112.57/62

(a)       Using the rates from Bank DDD and Bank EEE above, if you transact entirely with only one of these banks, determine which bank provides the best rate to hedge this exposure. What is the rate? Support your answer by showingall workings. (4 marks)

(b)          If you are able toconstruct your deal using the prices from both banks above (Bank DDD or Bank EEE) what is the best rate achievable (rounded to 2 decimal places) to undertake this transaction and why?

             Note: Show the sequence of trades and cash flows necessary to undertake this deal, leaving no residual flows. (4 marks)

(c)       In the following circumstances, identify whetherBendigo Bank is in the role of price maker or price taker:

(i)        BendigoBank phones Canberra Bank asking for a price in spot AUD/USD. (0.5 mark)

(ii)       Hilltop phones BendigoBank, dealing on a price in a 3-month AUD/USD FX swap. (0.5 mark)

(iii)      A broker shows BendigoBank a price in spot AUD/USD. BendigoBank trades on the bid. (0.5 mark)

(iv)             TheBendigo Bank asks the RBA for a price in spot AUD/USD. (0.5 mark)

(v)       BendigoBank shows a price in spot AUD/USD to a broker. The broker then advises that Bank GGG has traded with them on their bid. (0.5 mark)

(vi)             BendigoBank deals on a price provided by Bank DDD a price in a 2-month AUD/USD FX swap. (0.5 mark)

(d)          For part (d) only, assume the following holidays occur:

USA:            16 September 2016

Australia:   19 September 2016

Using a 2016 calendar, state the value date for each of the following transactions:

Deal date Transaction  
18 August, 2016 1-month AUD/USD FX swap (1 mark)
17 August, 2016 1-month AUD/USD FX swap (1 mark)
14 September,2016 Spot USD/JPY (priced at Westpac, Sydney) (1 mark)
15 September,2016 Spot AUD/USD (1 mark)

Criteria-based marking guide for Question 2

  Excellent
(Mark range: 11.5–15 marks)
Satisfactory
(Mark range: 7.5–11 marks)
Unsatisfactory
(Mark range: 0–7 marks)
(a) Ÿ  Correct rate identified

Ÿ  Detailed, thorough and correct justification and calculations

Ÿ  Correct rate identified

Ÿ  Basic and correct justification and calculations

Ÿ  Incorrect rate identified

Ÿ  Incorrect, unclear or no justification and calculations

(b) Ÿ  Correct and detailed calculations given

Ÿ  Correct identification of the best rate achievable

Ÿ  Detailed, thorough and correct justification of the best rate

Ÿ  Correct calculations given

Ÿ  Correct identification of the best rate achievable

Ÿ  Basic and correct justification of the best rate

Ÿ  Incorrect or incomplete calculations given

Ÿ  Incorrect identification of the best rate achievable

Ÿ  Incorrect, incomplete or no justification of the best rate

(c) Ÿ  5–6 correct identifications of price maker or price taker Ÿ  3–4 correct identifications of price maker or price taker Ÿ  Less than 3 correct identifications of price maker or price taker
(d) Ÿ  All 4 correct value dates Ÿ  3 correct value dates Ÿ  Less than 2 correct value dates

Insert your answers to Question 2(a)–(d) below this line

 

 

End of answers to Question 2(a)–(d)

 

Question 3     (35 marks | Word limit: 600 words)

To answer this question, use the pricing data provided in the case study information.

(a)       Determine which bank (Bank AAA or Bank BBB) has the best outright forward rates at which Hilltop can hedge the following future shipments.

Note: Show all workings, including FEC rates and AUD equivalent cash flows.

(i)        Expected shipping date: 5 October 2016.(3 marks)

(ii)       Expected shipping date: 6 November 2016.(3 marks)

(iii)      Expected shipping date: 24 November 2016.(5 marks)

(b)             (i)         Rework the pricing for the 5 October 2016 shipment to obtain the best possible hedging outcome using both the spot and FX swap prices provided by both banks.Show all relevant exchange rates and cash flows(5 marks)

(ii)       Explain the benefit of using this approach (from part(b)(i)) rather than just dealing an outright forward contract. (2 marks)

(c)       (i)        One or more arbitrage opportunities exist within the FX swap prices provided.
Identify this opportunity.(4 marks)

(ii)       Discuss what prevents Tianafrom undertaking this trade? (2 marks)

(d)          An FEC thatwas transacted earlier this year is due to mature soon with Bank BBB. It was used to exactly hedge export receipts from one of Hilltop’s US customers. The details of this transaction with Bank BBB are as follows:

Hilltop sells USD2,500,000.00at 0.7310 against AUD, value 5 September 2016.

However, the customer has contacted Tiana to advise that they made a mistake with their payment date and have made the payment for value one (business) day earlier than originally expected, namely2 September 2016.The USD account is expected to balance on that date, but the AUD account will be heavily overdrawn on 02 September, so it would suit to change the value date of this cash flow.

Show all the transactions needed with Bank BBB to compensate for this cash flow mismatch. (5 marks)

(e)          Tiana decides to hedge the second instalment of the JPY payment (due 5th December 2016) using an AUD/JPY outright forward contract. She asks Bank BBB for an indicative price for 3‑month USD/JPY FX swap. They provide the following information:

  • 3-month USD/JPY swap = 13/14
  • spot basis 112.10/15

Using this information and the AUD/USD FX swap information supplied earlier by Banks AAA and BBB in the case study, calculate:

(i)        thebestrate at which Tiana can hedge the second payment to the Japanese contractor(5 marks)

(ii)       the AUD equivalent of the payment.(1 mark)

Criteria-based marking guide for Question 3

  Excellent
(Mark range: 27.5–35 marks)
Satisfactory
(Mark range: 18.5–27 marks)
Unsatisfactory
(Mark range: 0–18 marks)
(a) Ÿ  Correct and detailed calculations for FEC rates and AUD equivalent cash flows for (i), (ii) and/or (iii) Ÿ  Correct but basic calculations for FEC rates and AUD equivalent cash flows for (i), (ii) and/or (iii) Ÿ  Incorrect, incomplete or no calculations for FEC rates and AUD equivalent cash flows for (i), (ii) and/or (iii)
(b) Ÿ  Correct calculations for (i)

Ÿ  Correct and thorough explanations offered for part (ii)

Ÿ  Mostly correct calculations for (i)

Ÿ  Correct basic explanations offered for part (ii)

Ÿ  Incorrect, incomplete or no calculations for (i)

Ÿ  Incorrect or no explanations offered for part (ii)

(c) Ÿ  Correct and detailed description of one (1) arbitrage opportunity

Ÿ  Correct and detailed calculations offered to support the arbitrage opportunity

Ÿ  Clear connection drawn between parts (i) and (ii)

Ÿ  Correct and detailed explanation of the restrictions of the role of treasurer

Ÿ  Correct basic description of one (1) arbitrage opportunity

Ÿ  Correct basic calculations offered to support the arbitrage opportunity

Ÿ  Generally clear connection drawn between parts (i) and (ii)

Ÿ  Correct basic explanation of the restrictions of the role of treasurer

Ÿ  Incorrect, incomplete or no description of one (1) arbitrage opportunity

Ÿ  Incorrect or incomplete calculations offered to support the arbitrage opportunity

Ÿ  Lack of connection drawn between parts (i) and (ii)

Ÿ  Incorrect, unclear or no explanation of the restrictions of the role of treasurer

(d) Ÿ  Correct and detailed calculations Ÿ  Correct basic calculations Ÿ  Incorrect or incomplete calculations
(e) Ÿ  Correct and detailed calculations for (i) and (ii) Ÿ  Correct basic calculations for (i) and (ii) Ÿ  Incorrect or incomplete calculations for (i) and/or (ii)

Insert your answers to Question 3(a)–(e) below this line

 

 

End of answers to Question 3(a)–(e)

 

Question 4     (9marks | Word limit: 200 words)

In the process of hedging sales receipts you request another bank, Bank CCC, to provide pricing for one of the exposures. They provide the following prices relating to the 6 November 2016 shipment:

5-month cash rates:

  • USD: 0.90%/1.00%
  • AUD: 2.80%/2.90%
  • Spot FX: AUD/USD 0.7112/22

(a)       Detail the transactions and cash flows needed to hedge the sales receipts from this shipment using the money market rate provided by Bank CCC, including the effective hedging rate achieved.
Show all calculations and clearly show all cash flows required using Bank CCC. (7 marks)

(b)          Determine which hedging method is best for Hilltop.(2 marks)

Criteria-based marking guide for Question 4

  Excellent
(Mark range: 7.0–9.0 marks)
Satisfactory
(Mark range: 4–6.5 marks)
Unsatisfactory
(Mark range: 0–3.5 marks)
(a) Ÿ  Correct and detailed advantage identified

Ÿ  Correct and detailed calculations

Ÿ  Correct basic advantage identified

Ÿ  Correct basic calculations

Ÿ  Unclear, incorrect or no advantage identified

Ÿ  Incorrect or incomplete calculations

(b) Ÿ  Correct identification of best hedging method Ÿ  Best hedging method not satisfactorily defined Ÿ  Incorrect or incomplete description of best method

Insert your answers to Question 4(a)–(b) below this line

 

 

End of answers to Question 4(a)–(b)

 

Question 5     (12marks | Word limit: 400 words)

Turning your attention to the purchase of new equipment from the US, and its associated funding requirement, assume the following applies:

  • The term of the borrowing is 360days. Interest is payable on all currencies every 180 days.
  • AUD/USD cross-currency swap: 360-day AUD BBSW versus USD LIBOR: minus 0.50% to borrow USD, paid at the maturity of the swap.
  • 360-day term cash rates: BBSW = 3.70% and LIBOR = 1.90%.
  • Spot basis (for all conversions in this exercise): 0.7120.

Tiana wishes to use USD sales receipts to directly service any debt facility. With this objective in mind, Tiana seeks input from the corporate dealer at Bendigo Bank on the feasibility of funding through the Australian marketversus funding through the US market, particularly given the attractive cross‑currency swap rate available to Hilltop.

(a)       Explain to Tiana the processby which these alternatives can be achieved. Show all cash flows, calculationsfor the borrowing.(8 marks)

(b)          Determine the effective interest rate of both alternatives for a 360 day borrowing. (Use 0.7120 as an arbitrary conversion rate for easier comparison in a single currency). Explain the most effective funding method?(2 marks)

(c)       Explain two (2) advantages and two (2) disadvantages of funding entirely via the US market. (2 marks)

Criteria-based marking guide for Question 5

  Excellent
(Mark range: 9.5–12marks)
Satisfactory
(Mark range: 5.5–9 marks)
Unsatisfactory
(Mark range: 0–5 marks)
(a) Ÿ  Correct and detailed explanation of methods

Ÿ  Correct and detailed cash flows and calculations

Ÿ  Correct basic explanation of methods

Ÿ  Correct basic cash flows and calculations

Ÿ  Unclear or incorrect explanation of methods

Ÿ  Incorrect or incomplete cash flows and calculations

(b) Ÿ  Detailed comparison of the effective interest cost of both the alternatives in AUD terms, highlighting similarities and differences

Ÿ  Correct, clear, substantiated and relevant conclusion drawn about the alternative that is the most effective

Ÿ  Detailed justification of conclusion skilfully integrated

Ÿ  Adequate comparison of the effective interest cost of both the alternatives in AUD terms

Ÿ  Correct and clear conclusion drawn about the alternative that is the most effective

Ÿ  Adequate justification of conclusion

Ÿ  Little or no comparison of the effective interest cost of both the alternatives in AUD terms

Ÿ  Incorrect, incomplete or no conclusion drawn about the alternative that is the most effective

Ÿ  Little or no justification of conclusion

(c) Ÿ  Thorough and correct and substantiated explanation of two (2) advantages and two (2) disadvantages of funding entirely via the US market Ÿ  Adequate and mostly correct explanation of two (2) advantages and two (2) disadvantages of funding entirely via the US market Ÿ  Little or no correct explanation of two (2) advantages and two (2) disadvantages of funding entirely via the US market

Insert your answers to Question 5(a)–(c) below this line

 

 

End of answers to Question 5(a)–(c)

Question 6     (14 marks | Word limit: 200 words)

(a)       Regarding the 5 June 2017 shipment, in order to determine the best hedging method
(FEC or FX option) you obtain the following FX option pricing from Bank CCC:

ATM forward AUD call (12 months) 3.11/3.15 % USD

ATM forward AUD put (12 months) 3.25/3.29 % USD

Spot basis: 0.7116/20

                         Note: Premiums are paid in AUD. The cost of funding the AUD premium is 1%.

             (i)        Nominate the most appropriate option based hedge to use and calculate the premium cost of the option used in this strategy. (3 marks)

(ii)              Assuming the swap pricing from Bank AAA and Bank BBB is still current, calculate the cash flows resulting from both an options based and FEC based strategy.(4 marks)

(iii)             Which is the most appropriate hedging method? Why?(2 marks)

Show all calculations.

(iv)             If the board felt that the currency would depreciate to 0.6600 rather than their view stated earlier, which strategy would provide the best outcome? Why?

Show all calculations.(3 marks)

(b)          Explain one (1) advantage and one (1) disadvantage of purchasing an out of the money option, rather than the ATMF options used above(2 marks)

Criteria-based marking guide for Question 6

  Excellent
(Mark range: 10.5–14 marks)
Satisfactory
(Mark range: 5.5–10 marks)
Unsatisfactory
(Mark range: 0–5 marks)
(a) Ÿ  Clear and thorough explanation of most appropriate hedging method

Ÿ  Detailed, substantiated and relevant justification of choice

Ÿ  All calculations shown correctly

Ÿ  Clear, correct and substantiated view expressed of preferred newstrategy

Ÿ  All correct calculations shown and integrated in justification of preferred strategy

Ÿ  Clear and adequate explanation of most appropriate hedging method

Ÿ  Adequate and relevant justification of choice

Ÿ  Most calculations shown correctly

Ÿ  Adequate and correct view expressed of preferred new strategy

Ÿ  Adequate and mostly correct calculations shown and integrated in justification of preferred strategy

Ÿ  Unclear or incorrect explanation of most appropriate hedging method

Ÿ  Little or no satisfactory or relevant justification of choice

Ÿ  Incorrect, incomplete or no calculations shown

Ÿ  Unclear, incorrect or unsubstantiated view expressed of preferred new strategy

Ÿ  Incorrect, few or no calculations shown and integrated in justification of preferred strategy

(b) Ÿ  Full and thorough explanation of one (1) advantage and one (1) disadvantage of using an open strike rate which is out-of-the-money

Ÿ  Integrated within the answer is a clear and detailed explanation of using this option rather than the ATMF options used previously

Ÿ  Adequate and correct explanation of one (1) advantage and one (1) disadvantage of using an open strike rate which is out-of-the-money

Ÿ  Integrated within the answer is an adequate explanation of using this option rather than the ATMF options used previously

Ÿ  Poor, incorrect or irrelevant explanation of one (1) advantage and one (1) disadvantage of using an open strike rate which is out‑of‑the-money

Ÿ  Unclear, little or no explanation and integration within the answer of using this option rather than the ATMF options used previously

Insert your answers to Question 6(a)–(b) below this line

 

 

End of answers to Question 6(a)–(b)

End of Assignment

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