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16 Case studies > Case 2: Foreign exchange hedging v speculation - Pg. 207

CASE STUDIES 207 Case 2: Foreign exchange hedging v speculation This case involved a medium/large New Zealand company that needed to purchase US$30 million of technical equipment from the United States. At the time of capital budget sanction the rate of exchange was US$1=NZ$1.28. On the actual date of purchase the rate was US$1=NZ$1.37. The return on this investment by the New Zealand company was posi- tive NZ$ and was based upon the rate of exchange at the time of budget sanction as follows: Capital budget approved (US$30m @ 1.28) NZ$38.4m Income NZ$40.4m Return NZ$2.00m (5.2 per cent) (For the purpose of this illustration we will ignore the time value of money and discounted cash flow.) To secure the return required at the time of budget sanction the NZ company needed to firm up (fix) the rate of exchange at US$1=NZ$1.28. Failure to do this might result in a loss on exchange that could partially (or more than) offset the expected return on the investment. In fact, failure to hedge against the exposure at the time of signing the contract for the equipment would leave the New Zealand company with an unlimited downside risk. Since the company was cash rich, it decided to purchase the US$ at the time of budget sanction. Dealing lines were arranged and the US$ were purchased at a rate of US$1=NZ$1.28. The company would earn US$ interest on the funds purchased and forgo NZ$ interest on the NZ$ used to purchase the US$. At the time NZ and US interest rates were similar, and since the time between budgetary sanction and equip- ment purchase was only a few weeks, it was considered that any loss/ gain on exchange on the interest differential was small compared with the avoidance of a loss/gain on the principal sum. By taking this type of hedging action the company avoided (on this occasion) the following NZ$ loss: Actual cost of US$30m @ 1.28 NZ$38.40m Cost on equipment purchase date, US$30m @ 1.37 NZ$41.10m Avoided loss NZ$2.70m