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Page 1 of 2 BFW2341 INTERNATIONAL FINANCIAL MANAGEMENT SEMESTER 2 2017, ASSIGNMENT TASK 1 ASSESSMENT WEIGHTAGE: 30% DUE DATE: FRIDAY 22rd SEPTEMBER 2017 by 12.00 noon Part A: Managing Transaction Exposure (20%) American Fast Track Inc. (AFT) operates high speed rail services in the U.S. AFT has placed an order to purchase rail cars from the Xinjiang Locomotives of China in June 2017. AFT has ordered 20 units of Multi-speed rail cars at the quoted price of USD2.5 million each, which totals to a p
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  Page 1 of 2 BFW2341 INTERNATIONAL FINANCIAL MANAGEMENT SEMESTER 2 2017, ASSIGNMENT TASK 1 ASSESSMENT WEIGHTAGE: 30% DUE DATE: FRIDAY 22 rd SEPTEMBER 2017 by 12.00 noon Part A: Managing Transaction Exposure (20%)   American Fast Track Inc. (AFT) operates high speed rail services in the U.S. AFT has placed an order to purchase rail cars from the Xinjiang Locomotives of China in June 2017. AFT has ordered 20 units of Multi-speed rail cars at the quoted price of USD2.5 million each, which totals to a payment of USD50 million. All the 20 units of this rail cars will be delivered to AFT in December 2017. AFT has agreed to pay 50% of its payable when the order is delivered and another 50% to be settled in June 2018. Xinjiang has invoiced this order in USD and will receive its receivables in USD. As the receivable amount is substantially large in USD, Xinjiang will face the exchange rate risk if USD continue to depreciate against the Chinese Yuan. Background Since the beginning of 2017, the U.S. dollar had been steadily depreciating against the Chinese Yuan (CNY). In January 2017, the dollar was trading around CNY7.22573/$ and by June 2017, it softened to 6.72475/$. This represented a 8% depreciation of the dollar against the CNY. Although many analysts had concluded that the U.S. dollar was undervalued during this period, it continued to show signs of weakening. Government interventions to strengthen the dollar was not  being discussed at this time. Issue While many forecasters were predicting an eventual appreciation of the U.S. dollar, for Xinjiang, the size of this contract which was denominated in U.S. dollars was seen as too large a transaction to be left uncovered. Therefore, you have been contacted by Xinjiang to analyze and recommend alternatives as to how this locomotive company can hedge its U.S. dollar transaction exposure. Data Having collected the CNY/US$ exchange rates from various financial institutions that have a dedicated foreign exchange department, you are provided with the following quotes:   Spot Exchange rate 180-day Forward 360-day Forward   CNY 6.72475/$ CNY 6.62335/$ CNY 6.22755/$   Page 2 of 2  Not satisfied with the lack of risk management opportunities, you decided to contact a few banks to obtain the latest interest rates:   U.S. 180-day interest rates : 4.000  –   4.345% p.a.   U.S. One year interest rates : 4.255  –   4.500% p.a.   China 180-day interest rates : 2.323  –   2.452% p.a.   China One year interest rates : 2.001  –   2.225% p.a.   The risk management executives at the banks you contacted also provided you with another alternative, which is to manage the exposure via currency options contracts. The available derivatives are as follows:   Option Contract On USD On CNY   Strike Premium Strike Premium   180-day Call Option CNY 6.500/$ CNY 0.03/$ CNY 6.700/$ 180-day Put Option CNY 6.650/$ CNY 0.05/$ CNY 6.600/$  360-day Call Option CNY 6.300/$ CNY 0.02/$ CNY 6.520/$ 360-day Put Option CNY 6.250/$ CNY 0.04/$ CNY 6.500/$ (a) Based on the information provided, analyze all possible alternatives for managing the foreign exchange risk exposure in the scenario above, and make a recommendation for the best alternative. (15%) (b) Justify your recommendation(s). (5%) Part B (continuation of the above scenario, 10%) On December 2017 and in June 2018, if the actual exchange rates between the U.S. Dollar and the Chinese Yuan is CNY6.8255/$ and CNY6.950/$ respectively: 1. How much unrealized gain / loss did Xinjiang face through your recommendation(s) from Part A during both the settlement periods? (3%) 2. In not more than 1,500 words: (7%) i. Explain how the unrealized gain / loss happen in each period of settlement. ii. Explain whether managing foreign exchange risk is worth the amount of effort required. iii. Explain whether a company like Xinjiang should just choose to remain unhedged. Please note that this is an essay. Therefore, all essay requirements, as can be found in your Q-manual applies. Students who do not abide by the guidelines will be penalized. Your marks will depend upon accurate calculations of the hedge alternatives and logical decisions made as the outcome of the analysis in part A. As for part B, marks will be awarded for clear explanation on issues raised and logical explanation backed by appropriate choice of theories articulated based on the units teaching. Page 2 of 2 Introduction Exchange rate risk management is an integral part in every firm’s decisions about foreign  currency exposure (Allayannis, Ihrig, and Weston, 2001). Currency risk hedging strategies entail eliminating or reducing this risk, and require understanding of both the ways that the exchange rate risk could affect the operations of economic agents and techniques to deal with the consequent risk implications (Barton, Shenkir, and Walker, 2002). The issue of currency risk management for non-financial firms is independent from their core  business and is usually dealt by their corporate treasuries. Most multinational firms have also  risk committees to oversee the treasury’s strategy in managing the exchange rate (and interest  rate) risk (Lam, 2003). A common definition of exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm (Madura, 2006). This essay will analyze the alternatives of how Xinjiang Locomotive of China can hedge its U.S. dollar transaction exposure as the exchange rate risk of USD continue to depreciate against Chinese Yuan, as Xinjiang is involved in receivable transaction exposure.This is an important matter for Xinjiang to hedge its exchange risk as the transaction involved a huge amount of money, USD50 million with American Fast Track Inc, (AFT) from United States. The issue regarding this situation is although many forecasters were predicting an eventual appreciation of the U.S. dollar, for Xinjiang,the seize of the contract which was denominated in U.S. dollar was seen as too large a transaction to be left uncovered. Therefore, this essay will suggest the best alternatives on how Xinjiang company can hedge its U.S. dollar transaction exposure. Transaction exposure is a degree to which the value of future cash transactions can be affected by exchange rate fluctuations (Madura, 2006). In this essay, there are four hedging alternative techniques that will be discussed. These are to remain unhedged (remain exposed), hedging with currency forward contracts, hedging with money market hedge (MMH) and hedging with options contract (Part A). It also will discuss relating to the how much unrealized gain or loss did Xinjiang face through the alternative that will be chosen as well as whether managing foreign exchange risk is worth the effort required followed by a question whether a company like Xinjiang should just choose to remain unhedged (Part B). The first technique is by remain unhedged. Suppose that Xinjiang decides to accept the transaction risk by not entering any hedging propositions.According to IRP if calculate the future spot rate of receivable at 180-day and 360-day, the future spot rate would be CNY6.66596/$ and CNY6.57885/$. Therefore the expected value of cash to be received by Xinjiang is CNY 166,649,000 which is uncertain, receivable in December 2017 and CNY164,471,250 receivable in June 2018. If we add the two periods of the receivable amount above, the total expected value of cash to be received is CNY331,120,250 for Xinjiang as a result of the foreign exchange transaction with American Fast Track Inc, (AFT) from United States. However, if the future spot rate is CNY6.72475/$, Xinjiang will receive only  CNY168,118,750, which is CNY1,469,750 lower in December 2017 and CNY3,647,500 lower receivable in June 2018. Receivable time Expected Future Spot Rate Expected Value from Remain Unhedged December 2017 CNY6.66596/$ CNY166,649,000 (uncertain)  ($25,000,000× CNY6.66596/$) June 2018 CNY6.57885/$ CNY164,471,250 (uncertain ) ($25,000,000× CNY6.57885/$) Total CNY331,120,250 The second technique is by using Forward Market Hedge. Forward contracts   allow a company to set the exchange rate at which it will buy or sell a given quantity of foreign currency in the future (on either a fixed date or during a fixed period of time). They are flexible instruments that can easily match future transaction exposures (generally up to one year).   Hedging in forward market here means selling $25,000,000 forward at the 6-month (180-day Forward) rate of CNY6.62335/$. And selling the othe $25,000,000 forward at the 12-month (360-day Forward) rate of CNY6.22755/$. In 6-month (December 2017), Xinjiang will receive $25,000,000 and exchange them at a rate of CNY6.62335/$, receiving CNY165,583,750 with certainty. In 12-month (June 2018), Xinjiang will receive $25,000,000 and will also exchange them at a rate of CNY6.22755/$, receiving CNY 155,688,750. In December 2017, the amount money received is CNY1,065,250 less than the uncertain CNY 166,649,000 expected from the unhedged position.While for December 2018, the amount receive is CNY 8,782,500 less than the uncertain CNY 164,471,250 expected from the unhedged position. The total amount receivable in both settlement period of December 2017 and June 2018 is CNY 321,272,500 which is certain. The forward contract creates a foreign exchange loss of CNY 2,535,000 {($25,000,000×(6.72475-6.62335)}in December 2017 and CNY12,430,000 {($25,000,000×(6.72475-6.22755)}. Contract Rate Receive from Forward Contract 180-day Forward CNY6.62335/$ CNY165,583,750 (certain) ($25,000,000×6.62335)
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