Hedging Alternatives

Lunar Capital Partners (LCP) is an Australian Private Equity firm. They invest in assets in both Australia and New Zealand. The fund predominantly borrows in Australian dollars and its distributions are denominated in Australian dollars.

LCP are considering purchasing a New Zealand auto-repair chain, AutoNZ, for a total consideration of NZD50m. If the deal took place, it would require LCP to pay this amount in one month from today.

The General Partners of LCP are concerned about the currency risk of this potential deal. They have asked you to discuss possible hedging alternatives with them. Specifically, they wish to consider the following alternatives:

• Leaving the currency unhedged

• Entering into an FX forward contract

• Using the money market to construct a hedge

• Purchasing an option with strike price equal to 0.9250.

The mid-price of the spot rate, S(AUD/NZD), today is 0.9180. They wish to consider three scenarios: where the spot rate appreciates 8% to 0.9914, where the spot rate depreciates 4% to 0.8813 and where the spot rate remains unchanged from today's level. Table 2 contains market prices available to LCP.

Table 2: Market Prices

'FX option premia are quoted in AUD required to purchase the stated option in a value of 1 NZD. For example, at a premium price of 0.0250 it would cost AUD 25,000 to purchase an NZD Call / AUD Put on NZD 1,000,000.

(a) Suppose they leave the currency exposure unhedged. Calculate the AUD re¬quired to purchase AutoNZ under the three scenarios, assuming that the bid-ask spread in 1 month's time is still 0.0010. If they leave the currency un¬hedged, and the deal goes ahead, how much additional AUD must LCP pay under the worst of these three scenarios (from LCP's point of view) relative to the unchanged spot rate?

(b) Suppose they enter into a forward contract to hedge the entire NZD amount. Specify the details of the contract (long or short) and the price at which the contract will be struck. If the deal goes ahead, LCP will be completely insulated from movements in the spot rate. However, if the deal does not go ahead, LCP must still honor the forward contract. Calculate the profit and loss on the forward contract under the three spot price scenarios listed above.

(c) Being sophisticated investors, LCP are aware of the covered interest rate parity arbitrage condition between relative FX spot and forward rates, and relative interest rates in Australia and New Zealand. Calculate the two-way price of constructing FX forward position via the money market and spot FX market. Do the prices in Table 2 admit an arbitrage opportunity? Are LCP better off transacting in the FX forward market or the spot market and money market to construct their desired forward position?

(d) Now consider the case where LCP purchase an option to hedge their possi¬ble FX exposure (assume again that they enter into an option contract that hedges the entire NZD amount). Which of the options in Table 2 should they purchase? How much premium does it cost in AUD?

(e) Carefully plot the total deal cost for LCP after they purchase this option assuming that the deal completes. Be sure to include all relevant details in this plot.

(f) Carefully plot the net portfolio profit profile at expiry for LCP after they purchase this option assuming that the deal does not complete.