Question

The current exchange rate between the US and Australian Dollar is $0.7700/A$. 

There is an expectation that the US Dollar will appreciate by 4% against the Australian Dollar over the year.

Company A is a US firm, and Company B is an Australian firm. They are involved in the foreign exchange market for two different reasons.

Company A has $1m cash on hand. It plans to take a one-year loan amounting to $2.5m from a US bank with an interest rate of 5% per annum. It will then invest the cash on hand and the loan amount into the Australian market for a year. The Australian market provides an interest rate of 10% per annum. The company expects that converting the US Dollar now to the Australian Dollar will allow it to grow at the stated investment rate for a year, and then converting the Australian Dollar back to the US Dollar will benefit them even after repaying the US Dollar-denominated loan.

Company B plans to buy a US Asset valued at $3.5m after a year. The US Dollar is expected to appreciate, but the percentage change is uncertain. The company worries about how much it must pay in Australian Dollars to cover the US Dollar purchase price. So, it creates a contract with an Australian Bank to purchase $3.5m at an exchange rate of $0.7900/A$ after a year.

i.   Are both companies' strategies, i.e., investment decision by Company A and risk reduction approach by Company B, beneficial to them? Show all relevant calculations? 

ii.    How will the companies be affected if the US Dollar depreciates rather than appreciates against the Australian Dollar after a year? 

[Please note hints and further instruction in the Word Question file]  Hints:

While the math may seem complex, it is solvable math, but it needs to be solved step-by-step, and you need to consider the underlying concepts.

Consider the positions of the two Companies.

The US company A is investing in A$ at a particular rate. Naturally, the investment will grow over the year. After a year, it will convert whatever amount the investment has grown back to the $. Notably, when making the initial investment, it borrows a certain amount from a US bank and will need to repay the loan after a year. So, will it be beneficial for the company to invest as suggested? A US Company deals in $, so all profits or losses, i.e., benefits, are to be determined in $ values.

Company B, the Australian Company, needs to purchase some $ after a year. It can either buy the $ from the market after a year, assuming the exchange rate will be as expected for the suggested appreciation of $, or create a contract with an Australian bank to purchase $ at a prefixed price in terms of A$. So, is the company's step correct? An Australian company deals in A$. So, they will consider all benefits in terms of A$. When purchasing a foreign currency, naturally, an Australian company will seek the strategy to pay less A$. 

The question suggests an appreciation of $, meaning the percentage change in $ against the A$ is given. We cover the percentage change formula. That may be used to understand the exchange rate after a year.