Western Mining's Economic Exposure Management (2001)

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 (Kim and McElreach, 2001, Malindretos and Tsanacas, 1995, and VanderLinden, 1997). This case recounts how Western Mining Company (WMC) assessed its foreign exchange exposure and decided to hedge these exposures (Maloney, 1990). WMC is an Australian based mineral producer with business interests in nineteen countries. It 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 competitors 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 venture 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 Deutsche marks. The company also decided to discontinue its practice of selling forward US dollar revenues, except when actual sales had been made. Case Questions I. Evaluate pros and cons of various exchange-hedging instruments and techniques. 2. What are the different types of foreign exchange risk WMC will encounter? 3. Explain why borrowings in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980s had backfired. 4. Explain why WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars. 5. What are two possible ways to hedge economic exposure? 6. Explain why WMC decided not to hedge its economic exposure. TEACHING NOTES FOR WESTERN MINING'S ECONOMIC EXPOSURE MANAGEMENT 1. Evaluate pros and cons of various exchange-- hedging instruments and techniques. …