Question 1 (12 marks) Imagine you are the treasurer of a NZ company exporting dairy products to the United States. All revenues are received in USD and all other expenses (e.g., R&D costs, costs of employees etc.) are incurred in NZ dollars. Required: (a) Discuss whether you need to hedge the foreign exchange risk and factors you need to consider when designing contracts to hedge the risks. (6 marks) (b) If the company is able to raise the price of its product in USD if NZD appreciates without affecting the sales volume, how would you adjust your recommendation in part (a) and sell your strategy to other executives? (6 marks) Provide a typewritten answer to (a) and (b) in no more than one-half (1/2) of a page in total. Hint: If the company is able to raise the price of its product in USD if NZD appreciates, what does it tell you about the company’s foreign exchange exposure? Which derivative security (securities) could be used to hedge this risk? There is no model answer to this question, you just have to provide reasoned explanations.

(a) As a treasurer of a NZ company exporting dairy products to the US, it is crucial to hedge the foreign exchange risk. This is because the company's revenues are in USD while expenses are in NZD. If the NZD appreciates against the USD, the company's revenues when converted back to NZD will decrease, potentially impacting profitability.

Factors to consider when designing contracts to hedge risks include:

1. The expected future exchange rates: This will determine the potential gain or loss from the hedging strategy.
2. The cost of hedging: This includes the cost of the hedging instrument and transaction costs.
3. The company's risk tolerance: This will determine the extent to which the company is willing to expose itself to foreign exchange risk.
4. The time horizon of the hedge: This will depend on the company's cash flow needs and business cycle.

(b) If the company can raise its product price in USD when NZD appreciates without affecting sales volume, it indicates that the company has pricing power and can pass on exchange rate fluctuations to its customers. This reduces the company's foreign exchange exposure.

In this case, the need for hedging may be reduced, but not eliminated. The company still faces the risk of NZD depreciation, which would increase its costs when converted to USD.

To sell this strategy to other executives, I would highlight the following points:

1. The ability to raise prices in USD provides a natural hedge against NZD appreciation.
2. However, hedging is still necessary to protect against NZD depreciation.
3. The cost of hedging can be viewed as an insurance premium to protect against adverse exchange rate movements.
4. A balanced approach combining natural hedging and financial hedging can optimize the company's risk-return tradeoff.

Derivative securities such as forward contracts, futures, options, or swaps could be used to hedge this risk. The choice of derivative would depend on the company's specific needs and circumstances.