Reference no: EM132008764

FX Exposure Management at Western Mining.1 It is critical for business executives to clearly understand the dynamic interaction of currency exposure and exposure management for their company’s long-term welfare. In the 1980s ,Western Mining Company (WMC) assessed its foreign exchange exposure and decided to hedge these exposures given the rapid globalization of its business. WMC was an Australian based mineral producer with business interests in nineteen countries. It was taken over in 2005 by BHP Biliton, an Anglo-Australian competitor, to create one of the largest mining groups in the world. But in 2000, WMC is the world’s third largest nickel producer, owns 40 percent of the world’s largest alumina producer (Alcoa World Alumina and Chemicals), and is a major producer of copper, uranium, gold, fertilizer, and talc. WMC builds its business on large, low cost, and long life assets, which are globally competitive.

Most commodities produced by Australian mining companies, including WMC, are exported and priced in US dollars. Thus, these companies would suffer significantly and their Australian dollar revenue would drop if the Australian dollar appreciated sharply against the US dollar. Given such an exposure, the conventional wisdom held that borrowing in US dollars would provide a ”natural” hedge against their dollar revenue stream. When forward markets began to develop in the mid-1970s, Australian mining companies often hedged up to 100 percent of forecasted revenues with a combination of debt servicing and forward contracts–often for periods up to ten years. In the early and mid-1980s, the Australian dollar declined sharply against the US dollar, and the “natural” hedge proved not to be a hedge at all, but rather an uncovered short position in the US dollar.   As expected, the decline in the Australian dollar increased the cost of serving US dollar debt. And those companies that had also sold forward their expected dollar revenue stream also suffered further foreign exchange losses as these contracts matured. The positive effect of the stronger US dollar on dollar-denominated revenues was offset by a prolonged slump in mineral commodity prices.

Although WMC too experienced some currency losses, it fared better than many of its com- petitors for two reasons. First, it had relied more on the equity markets to finance capital expenditures. Second, it had not participated in new major projects in the early 1980s. In 1984, however, the company contemplated investment in new copper, uranium, and gold mine, with capital costs expected to be about $750 million. Under arrangements with a joint ven- ture partner, the company planned to finance its share of the mine solely with debt, thereby increasing its total debt by a magnitude of two or three times.

When confronted with the need to decide the currency denomination of the debt, WMC concluded that taking a short position in US dollars, whether by borrowing or selling forwards, would not stabilize the volatility of its home country operating profits. Consequently, WMC decided to borrow in a basket of currencies that included Australian dollars, US dollars, Japanese yen, British pounds, and European euros. The company also decided to discontinue its practice of selling forward US dollar revenues, except when actual sales had been made.

(a) Evaluate the advantages and disadvantages of various exchange-hedging instruments and techniques. Also, distinguish financial from non-financial risk management approaches. You may present your result in tabular form separating instruments from techniques.

(b) What are the different types of foreign exchange risk WMC faces in its operations? How do they affect the company?

(c) Explain why borrowing in US dollars and forward sales of US dollar revenues by Aus- tralian mining companies in the 1980s had backfired. What about the 1990? You might want to research the evolution of the USD/AUD exchange rate.

(d) WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars. What are they trying to accomplish? What are the advantages and disadvantages of this course off action?

(e) Bonus problem. Define economic exposure. How would you go about hedging WMC’s economic exposure? What do you think of WMC’s decision not to hedge its economic exposure?