hedging in Australia

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There are three kinds of hedging instruments in the foreign exchange market, namely forward contracts, cross currency interest rate swap and foreign exchange options.  Forward contracts: are agreements between two parties to exchange two currencies at a specific time in the future. Forward contracts are the most popular hedging instrument because they do not require initial outlays like options. Forwards can be tailored to suit individual films’ needs. Besides, the future contracts do not exist in some mi nor currencies compared with forward contracts.  Cross currency interest rate swaps are the exchange of cash flows between two or more parties over given periods of time. An example of cross currency interest rate swap will be explained. Investors deposit US dollar into an Australian bank. When Australian residents want to borrow Australian principals from the banks, the banks will exchange US principals to AU principals at the foreign exchange market and lend them to Australian borrowers. Then, Australian borrowers pay interest in AUD. The banks do not want to take risk because of the fluctuation of foreign exchange rate. They enter agreements with swap counterparty to exchange AU interest payment to US interest payment. At the maturity, the banks can receive the amount of original debts they issued.  Foreign exchange options: give the holders the right, not the obligation, to purchase or sell an amount of currency to another at a given future date. Hedging in Australia:  Adaption to exchange rate fluctuations: after the prohibition of international transactions had been removed in the 1980s in Australia, around 3000 foreign loans denominated in Swiss francs were made although the borrowers did not have much knowledge about international transactions and hedging. When AUD fell more than 50% against Swiss francs, the borrowers had to pay a large amount of interest denominated in Swiss francs. After that, hedging has become popular in Australia.  The most popular hedging instruments are used in Australia are forward contracts and cross currency interest rate swap.  Time horizon of firm’s hedging: banks could prefer short term hedging contracts because the longer hedging contacts go on, the more risks they involve in. it can be explained that

for company with low credit rating, long term contracts would limit their ability to pay loans back.  It is reported that around 85% of Australian dollar trading in forwards and options is against the US dollar. Therefore, foreign currency exposure is predominantly to the USD. Measuring foreign currency exposure: The net foreign debt position of a country is often used as a measure of exchange rate depreciation. Around 60% of foreign assets are denominated in foreign currency terms. When AUS was depreciated 10% and no hedging instruments were used, it made net foreign liabilities decrease 12 billion AUD. When applying hedging instruments, firms convert 79% of foreign currencies on debt assets and liabilities. Therefore, the decline of net foreign liabilities was over double of the amount of money without hedging. Residual risk to consider:  Long horizon: most of hedging contracts are short terms (one year or under one year). Therefore, they cannot guarantee for the long term cash flows and revenue of companies.  Rollover risk: is related to renew the existing contracts or create new contracts. When the contracts end, if the foreign exchange rate depreciates or the investors do not want to continue the contracts, it will create risk for the currencies. In conclusion, Australia’s overall net foreign liability position could be interpreted as a substantial source of vulnerability to sudden exchange rate depreciation. In addition, overseas demand for Australian dollar assets has allowed Australian residents to further hedge their net foreign currency exposures

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