Hedging Currency Risk at AIFS Essay Sample
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- Category: currency
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Hedging Currency Risk at AIFS Essay Sample
Foreign Study (“AIFS”). Archer-Lock is the controller of AIFS and Tabaczynski is the CFO of AIFS’s high school travel division ACIS.
AIFS a student exchange organization that organizes educational and cultural exchange programs throughout the world. Founded in the U.S. in 1964, AIFS has annual revenues of close to $200 million and sent more than 50,000 students on their programs each year. AIFS has two major divisions, the Study Abroad College division, which sends college-age students to universities worldwide for semester-long programs, and the High School Travel division, which organizes one to four week trips for high school students and their teachers. The College division had higher margins than the High School division. As well, the High School division was effected heavily by world events. Negative events would drop sales dramatically. AIFS is a catalogue-based company.
They would send catalogues to colleges twice a year and to high schools once a year with smaller catalogues sent throughout the year. A key aspect of the catalogues is that AIFS guarantees its prices would not change until the next catalogue. Their customer base was loyal to AIFS because there were no surprises when it came to prices. Due to the international nature of this business, AIFS was exposed to huge currency risks. They receive its revenues in USD but incur its costs in other currencies, mainly Euros (EUR) and Pounds (GBP). Since exchange rates are constantly fluctuating, AIFS’s costs remain uncertain. However, the prices they charge are fixed because, as discussed above, they would always guarantee their prices in their catalogues.
To try and sure up these costs, AIFS is hedges the exchange rate. Their hedging policy is to cover 100% of their projected costs. AIFS worked with six banks to purchase their currency. The banks all granted AIFS lines of credit, which they would use to cover their hedging activity. The balances of these lines of credit are approximately $100 million USD. AIFS uses a combination of contracts and options in their hedging. Currently their corporate policies let the College division have up to 30% of their coverage in options and let the ACIS up to 50% of their coverage in options.
AIFS hedges to try and reach 3 objectives. Firstly they are trying to manage their bottom line risk. Secondly, they are trying to manage their volume risk. Lastly they are trying to lower competitive pricing risk. Archer-Lock and Tabaczynski are in charge of the hedging for their respective divisions.
2. Analysis of the Issues
If Archer-Lock and Tabaczynski did not hedge at all, they would bear the full brunt of the currency risk. As shown in Appendix A, if there was no coverage or hedging, AIFS would experience huge impacts, both positive and negative, when the exchange rates changed. If the dollar was strong and the exchange rate was 1.01 USD/EUR, then AIFS would be positively impacted by approximately $5.25 million. If the dollar was weak and the exchange rate was 1.48 USD/EUR, then AIFS would be negatively impacted by approximately $6.5 million. As discussed above in Part 1, AIFS’s prices are guaranteed and cannot be changed and as a result, it is imperative for them to limit their expenses. If there is a large swing in their expenses, their margins will be greatly affected. Especially if the exchange rate goes the wrong way, AIFS stands to lose all of its margins, which could bankrupt them.
If Archer-Lock and Tabaczynski completely hedged with forwards, they would be able to completely mitigate their currency risk. They would be unable to experience any upside or downside risk. As shown in Appendix A, 100% hedging with forward contracts would impact AIFS negatively by $145,000 no matter what the exchange rate becomes. The reason why AIFS is negatively impacted is that the 1-year forward rate is 1.2258 (as outlined in Exhibit 1 of the case), which is slightly higher than the 1.22 spot rate. If AIFS hedged completely with forwards, they would be able to control their expenses (at least at this sales volume) completely. The downside of using only forwards is that AIFS will not be able to experience any gains if the U.S. dollar strengthens.
If Archer-Lock and Tabaczynski completely hedged with options, they would be able to get rid of their downside currency risk and still experience some of the upside gains if the U.S. dollar strengthens, but they must pay the option premiums of $1,525,000. As shown in Appendix A, If the U.S. dollar strengthens and the exchange rate was 1.01 USD/EUR, AIFS would positively impacted by $3,725,000. This is not as much gain as AIFS would have gotten if they has not hedged at all because they needed to pay the option premiums. If the U.S. dollar was stable and the exchange rate stayed at 1.22 USD/EUR, AIFS would be negatively impacted by $1,525,000 because no matter what happens, they would still have to pay the option premiums. Lastly, if the U.S. dollar was weak and the exchange rate was 1.48 USD/EUR, AIFS would again be negatively impacted by $1,525,000. In this situation, AIFS would be protected from the full loss of the weakening dollar, but they again they would still need to pay the option premiums. The analysis in Appendix A assumes that the sales volume will be the same as the predicted 25,000 amounts. However, there is a risk that the volume of sales may fluctuate. If we compare Appendix B, which analyses the situation where the sales volume is only 10,000, and
Appendix C, which analyses the situation where the sales volume is 30,000, we can see that the impacts of the different hedging change. First, lets examine the effect of a change in sales volume on hedging with purely options.
Уxchange rate is at 1.01 USD/EUR, the exchange gain can compensate for the lower sales volume. However, if the option is not in the money, when the exchange rate is at 1.22 USD/EUR or 1.48 USD/EUR, AIFS can choose not to exercise the excess amounts. If the sales volume increases, then on top of having to pay the option premium, AIFS will have to purchase the excess costs at the spot rate, which exposes them to the downside risk again. 3. Comments on Solutions or Strategies
After all of the above analysis, I would recommend to use future contracts. Although compared to hedging with options you can receive better payoffs with options, the costs are too high. You must keep in mind AIFS’s main objective. They are trying to minimize their risks and to that extent future contracts provide the most stability no matter the situation. AIFS is not purchasing options or future contracts to have a speculative position. If Archer-Lock and Tabaczynski become too involved in speculating, they may end up hurting their company.