Assume that you are the CFO of a small Australian-based automotive components manufacturer, OZPRTS Co. As a result of the closure of the major automotive manufacturers’ plants in Australia (your former customers), OZPRTS Co. has taken on a large contract to produce 200,000 aluminium transmission casings per annum for a large EU-based automotive manufacturer with primary operations in Germany. OZPRTS Co.’s CEO has guaranteed a fixed euro price on the casings over the first three years of the contract. You are greatly concerned about the possibility of increases in the price of aluminium for two reasons. One is increased prices for the metal as a result of increases in its global demand given its use in the automotive and power transmission industries Another is the potential for the AUD price to increase due to the impact of adverse changes in exchange rates against the Australian dollar. You are also concerned with potential currency exposures on the revenue side of the contract.
a) Identify and discuss the exposures that OZPRTS Co. faces on the input cost side of this contract over the next three years.
i) identify the currency in which aluminium is priced (on global markets) and thus the exchange rate to which OZPRTS Co. is exposed due to its required purchases of aluminium over the next three years
ii) collect data on both aluminium prices and the appropriate exchange rate and, using charts, discuss the variability in these two prices/rates
iii) use appropriate diagrams to illustrate OZPRTS Co.’s exposure on purchases of aluminium to each, separately, of the global price of aluminium and the appropriate exchange rate. (40 marks)
b) Critically evaluate whether you should use options or futures to hedge against the risks that OZPRTS Co. faces from its purchase of aluminium. You should:
i) use appropriate diagrams to indicate both OZPRTS Co.’s exposure to, and the impact of, each of these derivative-based hedges on the cost of aluminium and the relevant exchange rate
ii) identify and explain any problems that might be present in the implementation of each of these derivative-based hedging strategies (e.g. accuracy, cost), both individually and in combination with each other
iii) choose one of these derivative-based hedge instruments, separately, for each of the exposures that OZPRTS Co. faces on its input side and justify your choice.
i) Identify your currency exposure on the revenue side of the contract and, using an appropriate diagram, illustrate OZPRTS Co.’s exposure on its sales of engine casings.
ii) choose whether to use an options or futures hedge against the currency exposure that OZPRTS Co. faces from its sales of engine casings, and use an appropriate diagram to illustrate the impact of the chosen hedge on this exposure
iii) Discuss the conditions under which this exposure may act as an offset to your exposures on the input cost side (i.e. as a buffer to profits), limiting your need to fully hedge this exposure.