Part A Case Scenario [Total 30 marks]

a)

Assume that you are the CFO of a service station chain named EZY Adelaide. Fuel is the major expense. The fuel price correlates strongly with the USD oil price and the AUD/USD exchange rate. The purchasing department has proposed locking in the fuel price for the next six months as forecasts from suppliers indicate that the oil price will rise significantly in the near term. Your CEO has queried this strategy arguing that the service station is not exposed to this risk.

As the CFO, do you agree or disagree with your CEO? Give your reasons in detail. (15 marks)

b)

Now assume that you change your job and move to a regulated network company called Green Electricity, working as a CFO. Regulated network companies own the poles and wires of the electricity grid and typically have their fees approved by government on a cost-plus basis. Your company has a $15 billion debt. As interest rates are at a record low, the accountant has suggested that it might be good timing to lock in rates for the next 15 years. Your CEO has queried this strategy on the basis that the regulated return for network assets set by the government is based on resetting interest rates every five years at a specific reset date.

As the CFO, do you agree with your accountant or your CEO? Give your reasons in detail. (15 marks)

Part B Research and Analysis from the Real World [Total 70 marks]

Assume that you are the CFO of a small Australian-based automotive components manufacturer, OZPRTS Co. As a result of the closure of the major automotive manufacturers' plants in Australia (your former customers), OZPRTS Co. has taken on a large contract to produce 200,000 aluminium transmission casings per annum for a large EU-based automotive manufacturer with primary operations in Germany.

OZPRTS Co.'s CEO has guaranteed a fixed euro price on the casings over the first three years of the contract. You are greatly concerned about the possibility of increases in the price of aluminium for two reasons. One is the increased prices for metal as a result of the increases in its global demand given its use in the automotive and power transmission industries. The other is the potential for the AUD price to increase due to the impact of adverse changes in exchange rates against the Australian dollar. You are also concerned with potential currency exposures on the revenue side of the contract.

a) Identify and discuss the exposures that OZPRTS Co. faces on the input cost side of this contract over the next three years. You should:

i) identify the currency in which aluminium is priced (on global markets) and thus the exchange rate to which OZPRTS Co. is exposed due to its required purchases of aluminium over the next three years;

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ii) collect data on both aluminium prices and the appropriate exchange rate and, using charts, discuss the variability in these two prices/rates;

iii) use appropriate diagrams to illustrate OZPRTS Co.'s exposure on purchases of aluminium to each of the global price of aluminium and the appropriate exchange rate separately.

(30 marks)

b) Critically evaluate whether you should use options or futures to hedge against the risks that OZPRTS Co. faces from its purchase of aluminium. You should:

i) use appropriate diagrams to indicate both OZPRTS Co.'s exposure to, and the impact of, each of these derivative-based hedges on the cost of aluminium and the relevant exchange rate;

ii) identify and explain any problems that might be present in the implementation of each of these derivative-based hedging strategies (e.g. accuracy, cost), both individually and in combination with each other;

iii) choose one of these derivative-based hedge instruments for each of the exposures that OZPRTS Co. faces on its input side and justify your choice.

(30 marks)

c)

i) Identify your currency exposure on the revenue side of the contract and, using an appropriate diagram, illustrate OZPRTS Co.'s exposure on its sales of engine casings.

ii) Choose whether to use an options or futures hedge against the currency exposure that OZPRTS Co. faces from its sales of engine casings, and use an appropriate diagram to illustrate the impact of the chosen hedge on this exposure.

iii) Discuss the conditions under which this exposure may act as an offset to your exposures on the input cost side (i.e. as a buffer to profits), limiting your need to fully hedge this exposure.