Australian Wood Chip Ltd (AWC Ltd) has signed a contract to sell USD 50,000 p.a. of wood pulp to Japan every year for the next 10 years. The company wants to hedge its foreign currency risk and therefore enters a fixed for fixed currency swap with its bank at a swap rate of AUD 5% p.a. in exchange for USD 5% p.a. The exchange rate at commencement of the swap is USD1=AUD1.2.

Answer ALL of the following questions:

1 What is the amount and currency of the principal that is exchanged between the bank and AWC Ltd at commencement and end of the swap?

2 What is the net income that AWC Ltd receives on its hedged position?

3 In your own words, discuss how effective the hedge will be at reducing foreign exchange risk and suggest any alternative or additional treatment options.