Case Study – Hedging Currency Risk at IDP

This is September 2019. You work in the finance team at IDP Education Limited (IDP). IDP is an ASX listed company (IEL) that is 50% owned by 38 Australian universities and headquartered in Melbourne, Australia.IDP Education Limited engages in the placement of students into education institutions in Asia, Australasia, and internationally. The firm offers services such as counselling, application processing, pre-departure guidance, examinations, English language teaching, client relations, digital marketing, online student recruitment, and shared services.The company was founded in 1969 and is headquartered in Melbourne, Australia.The company’s revenue is substantially attributed to its operation in Asia Pacific Region as shown in Figure 1. The geographical revenue breakdown shows that China continuously has been one of the major markets of IDP, contributing to averagely 31.4% of the total revenue. Other significant markets have been Australia with 12.2%, Japan with 11.5%, the US with 10.7%, India with 6.3%,South Korea with 2.4%, and Germany with 2.2% average of the total revenue. Figure 2 shows the operating revenue of company essentially stems from the IELS examination services and international student placementactivities. The reported revenue is denominated in Australian dollar (AUD).  In the recent years, income from the China market has been reported with positive growth rate. However, given the global concern about the ongoing trade warbetween the US and China, the company management is going to discuss a plan to hedge the income exposure in China with respect to the recent depreciation of Chinese Yuan (CNY). You are assigned by the finance manager to prepare for a currency hedging strategy on the currency pair AUD and CNY. The strategy will be discussed in the next board meeting.

You are suggested toconsidera variety of methods to manage the exchange rate risk. The mainfinancial instrumentsare the use of forward exchange contracts and currency options. The company’s hedging policy permits the purchase of forward exchange contracts up to 100% and currency options up to 100% of the currency exposure on the current and following year’s forecast cash operating expenses and revenues (net of any forecast cash receipts and payments in the same currency). Currently, the main currencies covered by the company’s hedging strategy are GBP, CNY and INR. With the stated concern about the CNY, you are required to develop the hedging plan for the last quarter of 2019 (December 2019). To assist your planning, the profit from China in 2020 is forecast to be ¥ 554,615,000. The companyplans to hedge up to 25% the foreign currency exchange rate exposure of the forecast net cashflow. Your manager also provides you with the interest rate information and inflation rate forecast in Table 1, and the financial instruments available for hedging in Table 2. Note that the use of option hedging will cost the firm an option premium of 5% of the CNY notional value. Forward and option rates are presented in Table 2. The initial exchange rate is ¥ 4.7939/A$.

You are required to complete the following questions as a guideline for the development of your hedging proposal:

  1. What gives rise to the currency exposure of IDP Education Limited? In this case, what is the firm’s exposure in Mainland China?
  2. Discuss the historical movement of the CNY/AUD exchange rate and provide reasonable forecasts using different appropriately fundamental models (Please provide a historical price chart over the last 3 months and necessary calculations). Following your knowledge of the exchange rate volatility, conduct the sensitivity analysis of the firm’s net cashflow (profit) with respect to 10% movement in the exchange rate on the projected receipt date.
  3. Provide a comprehensive discussion on the hedged A$ receipt’s sensitivity to the possible changes in the net cashflow forecast together with the potential ups and downs in the future exchange rate (A diagram can be used summarized the potential impact of the changes).
  4. Analyse the scenarios with three alternative strategies, namely Do nothing (no hedge), 100% forward hedge, and 100% options hedge. Compute the AUD value of these receipts under the assumptions of being unhedged, 100% forward hedge (100% of student costs), and 100% options hedge for 3 different possible exchange rates next year:4.7161 (Stronger CNY), 4.8505 (Stable CNY), and 5.3969 (Weak CNY).You can assume the net cashflow receiving date and the options and forwards maturity match. Present the results in the format of Table 3 below. Graph the impact receipts for being unhedged, 100% forward hedge, and 100% options hedge with the 3 possible exchange rates.
  5. Analyse the mix of options and in a similar way as in Question 3 and present the results using Table 4 template. Also graph the impact receipts for the mix of option and forward hedges with the 3 exchange rate forecasts.
  6. Based on your knowledge of the IDP’s foreign operations and the analysis of the exchange rate movement, which hedging strategy would you prefer and why?

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