Liu, Ching Hsueh (2007) Foreign exchange hedging and profit making strategy using leveraged spot contracts. Other Degree thesis, Victoria University.

Abstract

Australia currently adopts the floating exchange rate system; therefore the value of the Australian dollar is subject to volatility due to the influence of changing domestic and international economic circumstances. This volatility of the Australian exchange rate system is an issue that affects the majority of Australian businesses. With over fifty percent of Australian trading invoiced in foreign currencies, movements in the value of the Australian dollar can potentially improve or worsen Australian companies’ financial performance, and consequently, affect the national economic indicators. The importance of managing these currency risks not only stimulates countless studies attempting to capture a set of factors that are most relevant in contributing to the volatility of the Australian exchange rate system, but also encourages research attempting to develop an optimal hedging model that can assist Australian businesses to manage foreign exchange risk. From the review of existing literature, there appears to be a noticeable gap between theory and practice. Indeed, there exists a vast literature that looks at traditional financial derivatives such as options, futures, forward, and swaps for example, the Black-Scholes model is used for options pricings in the share and foreign exchange market. However, there is a paucity of research focusing on the leveraged spot market, both from an empirical and theoretical point of view. This thesis aims to minimize this omission by developing a model of speculation as well as a model of hedging, providing a theoretical framework and empirical simulations. Our model of speculation, developed in Chapter 3, adapts Krugman’s (1991) model of target zones, in order to theoretically determine the optimal number of leveraged spot contracts taken by a speculator. Moreover, using historical data on interest rates and spot rates, we conduct a simulation to provide insights into how changing economic factors affects the speculator’s position in the real world. In Chapter 4, we extend this model to show how speculation gains can be hedged with forward contracts. Traditional hedging methods involve the use of money markets and forward contracts; however, in Chapter 4, we describe how leveraged spot contracts can be used for hedging purposes. Moreover, we show that under some circumstances, the leveraged spot contract hedge outperforms these traditional hedging methods

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