Hedging exchange rate risk at Afterpay

Suppose today is February 27, 2020. You are a risk analyst working at the finance department at Afterpay, an Australian e-commerce platform that allows consumers to "buy now, pay later". Due to the growing importance of the US and UK segments, the company's Chief Financial Officer is worried about the impact of exchange rate risk exposure on its revenue over the next 6 months. As a result, you are asked to report outlining how exchange rate risk might affect the firm's profits. In addition, you are asked to assess different hedging strategies involving forward, futures and options. Further information and requirements for the report are as follows:

1.You are only required to focus on the exchange rate risk exposure of the US segment (i.e., focus on the AUD/USD exchange rate)

2.Using historical data on the movement of the AUD/USD exchange rate, provide a forecast for the exchange rate movement in the next 6 months. Conduct a sensitivity analysis of the firm's net profit with respect to a 10% movement (both up and down) in the exchange rate.

3.Assess the value of hedging exchange rate risk by conducting a scenario analysis with 3 different hedging strategies: (1) do nothing, (2) forward hedge and (3) option hedge. See Table 2 for further information on this task.

4.State any assumption when appropriate.

5.Outline the limitations of your analysis and discuss any further considerations.

6.Based on your analysis above, provide recommendation on an appropriate hedging strategy for the next 6 months.

Further information[1]

Table 1: Afterpay's key financial metrics

Source: Afterpay's half year financial result, February 27, 2020

Table 2: Scenario analysis

Forecast A$ net profit (unhedged)

Forecast A$ net profit (hedged)

Exchange Rate (A$/$)

Exchange Rate (A$/$)

Hedging strategy[2]

x-10%

x

x-10%

x-10%

x

x-10%

Unhedged

100% Forward

100% Option

75% Forward, 25% Option

50% Forward, 50% Option

25% Forward, 75% Option