As global trade and investments continue to grow, the future of Australia’s economic prosperity is highly pegged on the growth of foreign investments and exports. The Australian government is already aware of the significance of the Chinese market as for its exports. In 2005, the Government initiated what was termed as the China Strategy; the strategy was aimed at fostering better investment and trade relations with China by strengthening the links between the private sector and Chinese trading activities as in enhanced coordination. China depends on Australia for; copper and iron ore, wool and coal while Australia imports machinery (electrical and non-electrical), clothing, toys, plastic products and footwear.
The anticipated outcome of the expected volatility
For a business that imports toys and plastic products from China, it is more than obvious that it will be affected by the dynamic of macroeconomics involved in the trade between the Victoria government and China. At the moment, Australia’s current account seems to be getting better; exports are significantly increasing than imports. However, in absolute terms, the percentage increase in imports is higher than the change in exports. The current account is calculated using a baseline and imports have a higher base level. This means that to facilitate trade and foreign capital investments, the Australian dollar will appreciate.
The risk created by this volatility for loan and input prices
At the moment, the Australian dollar (AUD) is stronger than the Chinese Yuan. This is because the Yuan is undervalued and the Australian economy is doing relatively better as compared to other world economies. This implies that the interest rate is rising; a relatively higher interest rate than other countries (US and Japan) implies that the AUD is even more valuable (since it offers a higher return).
The increased demand for AUD is will drive up prices of inputs and make loan purchases and repayments more expensive. As the situation looks it is highly probable that the AUD will remain high relative to the Yuan. But there is speculation that the Chinese government is likely to revalue its Yuan, which is pegged at about 6.8 against the USD and the AUD is trading 92 cents against the USD. If indeed China revalues its currency, the Australian economy will certainly lose since the AUD is highly correlated with the USD. This creates the risk of aversion in the near future.
Risk management strategies
An importer of toys and plastic products from China with a variable rate loan can make use of derivatives to minimize risks by using hedging, leverage, or speculation strategies. Hedging a position is aimed at protecting a firm against risky assets. Since the market looks somewhat bullish on the AUD, there is a need to hedge against a likely return of the risk of aversion in the near future. One strategy would be to purchase a 1-year AUD/USD call option priced between (0.92- 0.93) as this year’s peak approaches, combined with a knock-in option with a strike price of about ( 0.80-0.83). The knock-in option simply trims the overall position cost.
This will allow the importer to reap benefits if the AUD appreciates in the short term. In the long run, the knock-in option will be a fall-back position even as the AUD continues to rise. The market will seem to over-price the Yuan in its anticipated appreciation. If this occurs, the company can also resort to other instruments such as swaps so as to minimize the anticipated volatility in the FX market. Another strategy would be to enter into an Interest rate swap contract in which they can pay for a floating rate (Libor), this will benchmark for short-term interest rates in the setting of loan and deposit rates.
However, the management of interest rate risk is a complicated affair with a myriad of options that are entrenched in conventional alternative investments instruments, especially with regard to loan repayment. Risk analysts may assess the potential volatility in returns and will often overlay derivative instruments (Swaps and options) to offset some of the risk, as it is virtually impossible to eliminate all risks. In fact, other risks such as competitive risk may occur as firms in China take advantage of their weak currency.
The choice of derivative products basically means giving up exposure to a particular interest rate (as in the case above), similarly the business will be taking counterparty credit risk—a risk of other party defaulting during the contract’s life. Options are on the other hand not flexible investment products.