In this study, the researcher hall discus the hedging strategy that MML could adopt for mitigating the risk related to the involvement of foreign currency in the business. In the initial part of the study, the researcher shall focus on the identification of the financial risks of the company. After this portion of the study, the researcher shall discuss the requirement of hedging for the sections of business.
(a) Identification of financial risks faced by MML
As per the case study of MML, the researcher could found that the company has taken a loan of USD 600 millions from a syndicated bank. Along with this debt, the company has also borrowed a variable rate debt of AUD 200 millions. In this context, Ruf (2013) stated that loan at foreign currency involves the risk of foreign exchange as the borrowers are to pay loan through the foreign currency. In this case, MML is to pay the loan at the US dollar. Therefore, the company is to face the exchange rate risk in the time of paying the loan to the bank.
In this case study, it has also been disclosed that the loan of the company has a term of ten years and the interest rate of the loan is floating in nature. In this same context, Norberg (2013) opined that the floating interest rate of loan considers a fixed portion and a variable portion, which depends upon the LIBOR. In this case, the loan has a floating interest rate at 2.5% above the three month US dollar LIBOR rate. Therefore, the company could face the enhancement in the LIBOR rate in future. If the LIBOR rate rises, the company would have to pay a higher amount of interest to the bank.
Apart from the loan in foreign currency, the company has borrowed loan in Australian dollars. The amount of loan was AUD 200 million, which was borrowed at the rate of variable rate. In case of variable interest rate, the lenders are to pay interest on the outstanding balance and the rate of interest is set out by considering the market interest rate (Norberg, 2013). In this context, it is to mention that if the market interest rate enhances, the company would have to pay higher amount of interest. Therefore, the company shall face the interest rate risk as well.
As the company involves in mining business, it is to store and produce mines, which are internationally valued in the US dollar. Therefore, if the price of the outputs of the company decreases in the international market, the company would face loss. Therefore, the foreign exchange rate risk is another crucial risk that could affect the company in near future, as opined by Ruf (2013), a fall in the price of US dollar would result in increase in the gold price and copper price in the Australian dollars. Therefore, the company would face the relative risk of enhancement in the US dollar price in the international market. In addition to that, the researcher is to mention that as the company involves in producing gold and copper, it comprises of risk regarding the change in price of such commodities. This kind of risk of the company could also include in the commodity rate risk. Therefore, the researcher is to mention that the company would face exchange rate risk, commodity rate risk and interest rate risk in operating the mining business in Australia.
(b) Recommendation for hedging strategy
From the above discussion, the researcher could mention that the company would face interest rate risk and the foreign exchange rate risk as the primary financial risks. As stated by Loss (2012), companies could avoid the financial risks by taking proper hedging strategies as hedging strategy minimises the risk regarding interest rate and currency exchange mismatch. In this context, the researcher is to mention that the company could adopt the hedging strategy in order to mitigate the risks, which have been discussed above. In this regard, it is to mention that the company has taken loan in foreign currency, interest rate of which depends upon the LIBOR (London Inter-Bank Offer Rate). Therefore, the company is required to hedge this risk in order to avoid the risk of enhancement in the LIBOR. Therefore, the company is recommended to take the interest rate future as the hedging strategy to minimise the above discussed risk. As the loan has been taken for 10 years, risk of change in the LIBOR is high, and therefore, this risk is required to be hedged by the management of MML.
On the other hand, it is to mention that the company has taken loan of AUD 200 millions at variable interest rate. In this context, the researcher is to mention that the hedging strategy is irrelevant in case of fixed interest rate as the rate of interest is predetermined in fixed interest rate regime (Bodie, 2013). However, the variable interest rate enhances the risk of enhancement of interest burden as the interest rate depends upon the market condition. In this context, Norberg (2013) noted that the interest rate in Australia depends upon the RBA Cash rate as the commercial banks are to borrow fund at the rate of liquid cash rate of Reserve Bank of Australia In this context, the researcher is to mention that the cash rate of Reserve Bank of Australia has shown a decreasing trend over last twenty years (Figure 1). Hence, the company could expect a decline in the Cash Rate in future, and therefore, the company is not required to hedge this risk of variable interest.
(c). Recommendation to MML
In the above portion of the study, the researcher has seen that the company is to take the hedging strategy to minimise the risk related to foreign loan’s interest and the foreign exchange rate. In this context, the researcher is to mention that the company is required to adopt interest rate future strategy to minimise the risk of the floating interest rate (Chan et al. 2015). In this contrary, Arouri et al. (2012) stated that the companies are to take the interest rate SWAP strategy to mitigate the risk. In this context, the company is to take the strategy of interest rate swap strategy to minimise the risk of floating interest. For this, MML is to make contract with bank to swap the floating interest rate to fixed interest. In this context, it is to mention that the fixed interest rate in Australia is 5% for a term above 5 years (Ruf, 2013). Therefore, the company is to pay interest at the rate of 5% per annum instead of floating interest rate at the rate of 2.5% plus the LIBOR. On the other hand, the company has been recommended to hedge the exchange rate risks, and therefore, it is to make forward agreement with the bank. In this regard, it is to mention that the company is to make a forward agreement to exchange US dollar at a predetermined exchange rate. This rate is required to be set out by the company. In the time of exercising the forward agreement, the company would have the right to exercise the contract.
In this context, the researcher is to mention that the company would have to pay premium if it takes derivative options such as options and futures. As stated above, the company needs not to take any strategy regarding the risk of enhancement in interest rate in the local market off Australia. If the company plans future strategy regarding the future strategy, it has to pay premium to the bank. As the probability of decline in the interest rate is seen as low, the hedging strategy for variable interest rate is to be considered as irrelevant. If MML takes future strategy to mitigate the risk, it shall pay interest to the bank, which shall result in loss to the company. Moreover, if the company makes future or option contract for the risk of decrease in the commodity prices, it would have to incur loss as the probability of decline in gold price and copper price is low. Therefore, the researcher has recommended not adopting the future strategy regarding the risk of commodity prices.
In this context, the researcher is to mention that the company is to take the strategy to minimise the risk of exchange rate as the exchange rate of AUD and USD reflected a fluctuation over past decade. The researcher has recommended adopting proper strategy regarding the exchange rate as the company is to evaluate the outputs in the US dollars. For this reason, MML is to make currency forward contract with the bank. As stated by Loss (2012), companies are required to pay premiums while entering into the currency future contract as this kind of contract carries the exchange rate risk. Therefore, the company is to incur the forward premium if it enters into the forward contract. As the fluctuation of the exchange rate of USD and AUD is relatively high, it would be profitable to enter into the currency future contract.