Question 3: (Total 11 marks) Crystal Wave Ltd. (CWL) is a Sydney based company t

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Question 3: (Total 11 marks) Crystal Wave Ltd. (CWL) is a Sydney based company that manufactures electronic ear implants. CWL manufactures its ear implants in Australia and exports them to Europe, which accounts for more than half of its total revenue. On the 1st of September 2016, CWL signs a contract with its European distributor in which CWL agrees to deliver 30,000 ear implants and receive EUR24 million on the 1st of December 2016. The exchange rate at the time of signing the contract is 1 EUR = 1.40 AUD. The gross profit margin based on this exchange rate is 30%. Required: (a) If CWL is concerned about the exchange risk, how can it hedge the risk using a future or forward contract? (3 marks) (b) Suppose the exchange rate changes to 1 EUR = 1.30 AUD when CVL receives the Euro payment. In order to maintain the same profit margin, how much must it sell these ear implants for in Euro? (5 marks) (c) Based on your answer to part (b), briefly explain why export-oriented countries want to devalue their currencies, especially in times of economic difficulty. (3 marks)

Explanation / Answer

(a)

CWL is an Australian company and is expected to receive the payment in Euros, 3 months (Dec-1) after the contract signing date (Sep-1). Since the payment will be received in a foreign currency (Euro) after 3 months, it runs the risk of Euro being depreciated agaisnt AUD.

To hedge this risk, CWL can enter into a 3-month forward (or future) contract to sell 24 Euro Million in exchange of AUD at a fix rate, say the current rate of 1 EUR=1.40 AUD. In that case, its payment in Australian Dollars is secured as it can sell 24 Euro Million to receive 24*1.40 = 33.6 Mn AUD.  

(b)

Firstly, calculate gross margin in AUD at the inital exchange rate of 1.40 AUD:

Since, 24 million Euros equal 24*1.40 = 33.6 Million & gross margin is 30%;

Gross Profit = AUD 33.6 million * 30% = AUD 10.08 Million

Profit on each implant is equal to 10.08 Million divided by 30,000 pieces

i.e. 10,080,000/30000 = AUD 336 per piece

Also note that Selling Price in Euro equals 24,000,000/30,000 = EUR 800  

Now,

The value of AUD received at exchange rate of 1.30 AUD = Euro 24 Million * 1.30 = AUD 31.2 Million.

However, to achieve a gross profit of AUD 10.08 million, the company needs to achieve a sale value of AUD 33.6 Million

Previously, Sale Value in AUD of 33.6 Million was determined as = 30,000*800*1.40 (i.e. Units Sold * Price per Unit in Euro * Exchange Rate)

Let the new sale price in Euro be 'P', then:

33.6 Million = 30,000*P*1.30 (Units Sold * New Price * New Exchange Rate)

Solving the equation, we get P = EUR 861.5384

(CROSS CHECK : Gross Profit in AUD = 30% of (30,000 * 861.5384 * 1.30) =AUD 10.08 Million, which is the same as before)

c)

Devaluation results in weakening of domestic currency against foreign currency. This, in our current example, would mean that Australian Dollar will weaken against the Euro, for example - from 1 Euro =1.40 AUD to 1 Euro = 1.50 AUD.

For an export oriented country (Australia, in this example), this would mean additional profit as payment is received in Euros.

Numerically, if original price was 800 Euros & exchange rate was 1.40.

Sale value was 33.6 Million (30,000*800*1.40)

With the same sale price, the value received would now be 30,000*800*1.50 = AUD 36 Million

Thus, export oriented economies prefer to devalue their currency so that their total exports will increase in value as the currency is weakened.

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