Imagine you are the Treasurer of a large Australian Oil Company (also Company''). Your company extracts oil from its oil wells in Western Australia. All extraction and other operating costs (e.g., costs of employees, oil extraction costs etc.) are incurred in AUD (Australian dollars). However, nearly all oil is traded in the international markets and the price of oil is denominated solely in USD (United States dollars). The Company's strategy is to maintain a constant level of oil extraction from its oil wells, where there is little flexibility to change production or output of oil in response to changes in the global oil price. Your company policy is not to use any futures, forward contracts or other derivatives to hedge the price of oil (denominated in USD) or foreign exchange risk. However, you can decide how to finance your operations and may borrow in either AUD or USD. Your local bank manager therefore suggests the company should borrow in USD as a hedge against revenues from oil sales denominated in USD. The directive from the Board of Directors to you as the Treasurer is to minimise the variance of the company's profit denominated in AUD. Thus, before following your bank manager's advice you undertake some statistical analysis and find that the correlation coefficient between the strength of the AUD and the USD price of oil is 0.85 (significant at the 1% level). Required What do you think of your local bank manager's advice? Imagine you are the Treasurer of a large Australian Oil Company (also Company''). Your company extracts oil from its oil wells in Western Australia. All extraction and other operating costs (e.g., costs of employees, oil extraction costs etc.) are incurred in AUD (Australian dollars). However, nearly all oil is traded in the international markets and the price of oil is denominated solely in USD (United States dollars). The Company's strategy is to maintain a constant level of oil extraction from its oil wells, where there is little flexibility to change production or output of oil in response to changes in the global oil price. Your company policy is not to use any futures, forward contracts or other derivatives to hedge the price of oil (denominated in USD) or foreign exchange risk. However, you can decide how to finance your operations and may borrow in either AUD or USD. Your local bank manager therefore suggests the company should borrow in USD as a hedge against revenues from oil sales denominated in USD. The directive from the Board of Directors to you as the Treasurer is to minimise the variance of the company's profit denominated in AUD. Thus, before following your bank manager's advice you undertake some statistical analysis and find that the correlation coefficient between the strength of the AUD and the USD price of oil is 0.85 (significant at the 1% level). Required What do you think of your local bank manager's advice
