Question 1

SECTION B: ADVISORY REPORT

AeroTurbine Inc (AT) is a US-based developer of offshore wind farms. The company's base currency is the US Dollar ($). AT has recently signed a contract to purchase specialized turbine blades from a European manufacturer. The payment of €50 million is due in exactly six months.

AT's Treasury department is concerned about the volatility of the EUR/USD exchange rate and is considering hedging the exposure. The treasury is currently operated as a cost center, but the CFO is considering transitioning it to a profit center.

Foreign Exchange Data:
Current Spot Rate ($/€): 1.1520 - 1.1540
Six-month Forward Rate ($/€): 1.1610 - 1.1635

Currency Options (Over-the-Counter):
AT's bank has offered a six-month European call option to buy Euros at a strike price of $1.1600/€ for a premium of $0.025 per Euro. The premium is payable immediately.

Interest Rates (Annualized):
US Dollar: Borrowing 4.5%, Investing 2.5%
Euro: Borrowing 3.0%, Investing 1.0%

REQUIREMENTS:

(a) Calculate the expected US Dollar ($) cost of the €50 million payable in six months using:
(i) A Forward Exchange Contract.
(ii) A Money Market Hedge.
(iii) The Over-the-Counter (OTC) Currency Option (assume the option is exercised if the spot rate in six months is $1.1800/€, and calculate the total cost including the future value of the premium). (12 marks)

(b) Based on your calculations in part (a), recommend the most appropriate hedging strategy for AeroTurbine Inc, discussing the advantages and disadvantages of the currency option compared to the forward contract. (6 marks)

(c) Discuss the implications, benefits, and risks of transitioning AeroTurbine's treasury function from a cost center to a profit center. (7 marks)

Accepted Answer

1. For the forward contract, multiply the payable by the higher offer rate. 2. For the money market hedge, work backward: discount the EUR amount, convert at spot, then compound the USD amount. 3. For the option, calculate the premium, compound it to future value, and add it to the exercise cost. 4. Compare the three costs to make a recommendation. 5. Discuss treasury centers focusing on risk vs. return and the core business of the company.

Question 2

What mistakes do candidates make on this ACCA question?

Accepted Answer

Using the wrong side of the bid/offer spread. Remember: 'Buy High, Sell Low' from the bank's perspective. Another common error is forgetting to calculate the future value of the option premium, as the premium is paid at T=0 but the comparison is made at T=6 months.

How to approach this question

Full Answer

Common mistakes

Practice the full ACCA AFM — Advanced Financial Management Practice Exam 2

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