We use cookies to give you the best experience possible. By continuing we’ll assume you’re on board with our cookie policy

The American Institute for Foreign Study Currency Hedging Solution Essay Sample

essay
The whole doc is available only for registered users OPEN DOC
  • Pages:
  • Word count: 3569
  • Category: currency

A limited time offer!

Get a custom sample essay written according to your requirements urgent 3h delivery guaranteed

Order Now

The American Institute for Foreign Study Currency Hedging Solution Essay Sample

The American Institute for Foreign Study, also known as AIFS, is a student exchange organization that specializes in academic and cultural exchange programs for both college and high school students. The AIFS was founded by Sir Cyril Taylor in 1964, in the United States, and is split into two divisions: the Study Abroad College division, based in London, and the High School Travel Division, based in Boston. Christopher Archer-Lock and Becky Tabaczynski, are the controller and CFO for the college and high school divisions, respectively.

Approximately 50,000 students travel per year with AIFS, and the company currently has annual revenues nearing 200 million dollars. Both the college and high school divisions are focused on American students studying abroad. Europe and Australia are two common destinations shared by the divisions. The college division also travels to Russia and South Africa while the high school division travels to the Americas, China and Africa. The AIFS is also associated with other divisions including the Au Pair, Camp America, and Academic Year in America divisions, which conversely to their regular divisions, place non-American students in the United States.

The two divisions, both college and high school, are susceptible of reacting to world news and events close to their travel dates. However, the high school travelers are most likely to react to worldwide news. Some of these events in the past that have affected AIFS revenues include the 1986 terrorist attacks, the 1991 Gulf War, the 2001 September 11 attacks and the 2003 Iraq War.

Since AIFS is predominantly working with American students traveling abroad, there are different types of financial risk that affect their potential for profit from providing these services to the students. AIFS’ revenues are primarily deposited in US dollars, while the costs are typically incurred in Euros and GBP, or British Pounds. This discrepancy between revenue and expense currencies is known as a currency mismatch.

AIFS distributes catalogs with travel destinations and pricing for students semiannually and annually for the college and high school divisions, respectively. The high school division also distributes a few small catalogs throughout the year in addition to the annual catalog. AIFS guarantees that the prices won’t increase before the distribution of a second catalog. Drastic increases or changes in the prices are frowned upon by AIFS since 70% of their clientele from the high school division are returning customers; they do not want to risk losing their customer base to a competitor because of a price increase.

In order to put together a suitable catalog for the college division with appropriate pricing, the AIFS marketing and operations managers put together a sales forecast including what they predict to be important events that may affect the sales of the coming catalog year. This forecast is done well over a year in advance, since the two catalogs that are distributed are finalized the summer before the first summer catalog for the year is to be distributed.

The high school catalog is geared towards student travelers who have not traveled abroad before. Because of this, the programs highlighted in the catalogs contain all inclusive packages from the airfare to the hotels to the tour guides. This makes the packages nearly endless in scope, so the catalog typically has over 35,000 different pricing packages. The pricing strategy for these types of packages is to increase the prices steadily from year to year. By raising the prices in small increments, the high school division is able to keep its client base of which nearly 70% of their customers are returning customers. Those returning customers are typically teachers and academic advisors who bring new students each year to the program.

The pricing of both the college and high school divisions is based on their cost base, competitive pricing and the hedging activities.

There are three types of risk that AIFS faces with respect to currencies: bottom-line risk, volume risk, and competitive pricing risk. Bottom-line risk is defined as “the risk that an adverse change in the exchange rates could increase the cost base”. Volume risk is the risk of having too much or too little of the currency based on the fact that projected sales will be different than the actual sales. The third type of risk is competitive pricing risk and is the fact that AIFS cannot change its prices even if the currencies are changing for fear of losing their customers. In order to manage, or ultimately minimize, these risks, AIFS uses currency hedging techniques. Hedging activities begin approximately six months before the prices are due for the catalogs for the college division. For the high school division, the hedging took place throughout the year: 25% by December, 40% by the end of March and 100% by June when the pricing for the catalog is due.

Problem Statement

AIFS wants to offset any change in the exchange rates that may adversely affect their profit margins by using currency forward contracts and currency options. These hedging activities work to offset the three types of risk defined above as bottom-line risk, volume risk, and competitive pricing risk. Since these hedging activities must be put in place two years before the actual year of sales, AIFS must decide the proportion and cost coverage level as a function of the forecasted sales for the projected year without knowing the actual sales. Currently the policy is to hedge, or cover, 100% of the forecasted sales but this is negotiable. AIFS also has to comprehensively forecast the exchange rates in order to efficiently choose their hedging strategies. Overall, AIFS needs to reevaluate their hedging goals and strategies in order to offset their risks associated with the exchange rates more effectively and efficiently by choosing the percent of coverage and the proportion of currency forward contracts and currency options that offset any negative impact on sales that are attributed to the bottom-line risk, volume risk, and competitive pricing risk that AIFS is facing.

Detailed Analysis and Application of Course-related Methodologies Should AIFS fail to properly manage their bottom-line risk, the company could potentially be put out of business. As Tabaczynski noted; without hedging, an adverse change in exchange rates, even by 30% may take AIFS out of business. This shows the sensitivity of AIFS operation to the exchange rate. In other words, currency risk is a major risk for the firm and it is critical to the firm’s survival. The safest strategy for AIFS would be to cover 100% since the risk is too high to ignore. In order to accomplish a 100% hedge of their costs, the company has a couple of options available to them. AIFS can engage in forward and futures contracts or they can utilize options.

The primary difference between contracts and options is that under a contract, the company is locked into the agreement. While this can benefit the company, there is also potentially for this strategy to end up costing them more in the long-run. If the exchange rate were to favorable change between the strike date and the deal date, the company would still be forced to purchase the currency at the higher rate. Options on the other hand offer the right, but not the obligation to purchase the currency. AIFS currently allows the college division to use up to 30% options while the high school division can use 50%. It seems futures are less attractive for the firm as they are not as flexible as options. Therefore, it would be safer and financially feasible to place more weight on options than futures. In the case of options, the loss is known beforehand in the form of the premium paid for the option and is a set price. The loss under a contract is any time the exchange rate shifts favorably, yet AIFS still has to purchase at the higher rate. Given this, Tabaczynski believes that options are a better alternative to contracts and actually lead to a more stable company.

US Trade Deficit and Direction of Currency Movement:
Balance of trade is one of the major determinants of exchange rate. A trade deficit would increase the pressure on the USD and eventually will lead to depreciation. This problem is more acute from late 1990s. This is also evident from the Exhibit 5 where we see the weakening USD against European Euro. It is very likely that this trend will continue given the increasing US trade deficit. Therefore, AIFS could expect a weaker dollar in the future.

Interest Rate Parity and Fisher Effect
Current interest rate on USD is 1% while the interest rate on Euro is 2%. According to the interest rate parity and Fisher effect, USD will be stronger and the Euro will be weaker in future. AIFS should use the interest rate parity as a guide to predict future exchange rate movement. Our analysis shows that future US dollar exchange rate would be around (1.2273*(1.01/1.02)= $1.2153 which is lower than current spot rate. Future dollar exchange rate appreciation is also indicated in forward exchange rates quoted for both six month and one year against major currencies. The rates quoted especially for Euro and British pound show a stronger US dollar exchange rate.

AIFS Monthly Currency Status Report
The monthly currency report shows higher percentage of currency risk hedged using futures rather than options. There is currently only one options contract in this monthly currency report out of six contracts, though according to Tabaczynski’s comment, futures are unstable compare to options and options lead to more stable company.

Shifting Box
Archer-Lock has summarized the relationship between sales volume and the market value of the USD in a two-by-two matrix known as the shifting box. Based on this matrix, both square three and four look attractive to the AIFS because an increase in sales volume has a much greater positive effect on the firm’s cash flow than the loss from a change in the exchange rate. From our analysis we found that though square three looks more attractive given the favorable exchange rate and increase in sales volume, however, square four has much more synergy where the increase in sales increases the overall gain faster than the gain from a favorable exchange rate.

From our analysis, we also found that the gain is maximized when 100% of the risk is covered. So we believe AIFS should use 75% of options and 25% of futures. This strategy is also in support of the AIFS Shifting Box where both square three and four fall on this line.

Volume Risk
Volume risk is the highest in the case of sales volume 10,000. If sales come much lower than expected, futures are not an ideal hedging instrument. If AIFS places a higher percentage on futures, the risk increases as the AIFS has to buy the excess amount hedged. On the other hand, options give the right to step away with a minimal loss: the loss of the premium paid. Therefore, volume risk could be minimized when AIFS uses a higher percentage of options. This is also evident from our analysis, which shows relatively higher exchange loss when the volume comes much lower than expected (10,000).

Bottom-line Risk
Bottom line risk increases when the position is uncovered or due to an unexpected increase in sales volume and exchange rate moves against the AIFS. This is notable in our analysis especially as sales volume comes in much higher than expected and the exchange rate is in the money. The additional money needed has to be purchased from the open market at a higher rate than previously expected. From our analysis, we found that an increase in sales volume by an additional 5,000 units and the depreciation of USD by $0.26 increased the overall cost base and at the same time increased the gain. Here the gain from increased volume is greater (20%) compared to cost increase in exchange rate which is 17.57%. so the net effect is a gain.

Competitive Risk
Finally, the competitive risk depends on the effectiveness of AIFS hedging strategies. If the chances of winning are 50% as per Tabaczynki’s comment, meaning that there is a greater competitive risk. Therefore, half the time, AIFS would be wrong about its expectation and hence its pricing would not be in favor of AIFS. However, the level of competitive risk also depends on the success of competitors beating the market. If competitors have same level of success like AIFS, the competitive risk might not be that bad.

Formulation and Evaluation of Alternatives
Formulation and evaluation of alternatives
Volume 10, 000, rate $1.01: No hedge
When sales become 10,000 and actual spot rate $1.01, there is no combination better than no hedge. However, we shout note that this strategy falls on square one of shifting box. Volume is low and rate is out of the money. There is an extremely high volume risk associated with this strategy. Hence, this is undesirable Volume 10,000, rate $1.48: 50% cover: 25% options and 75% contracts If the sales volume turns out to be 10,000 and actual exchange rate $1.48, combination of 50% cover, 25% options and 75% contracts give lowest possible cost base. However, the volume risk is very high and rate is in the money. This strategy falls to square 2 of the shifting box. Hence, this is not a desirable according to the AISF. Volume 10,000, rate $1.22: 25% cover: 0% options and 100% contracts If the sales volume turns out to be 10,000 and actual exchange rate $1.22, lowest possible cost combination is 25% cover, 0% options and 100% futures. Here the only risk comes from volume, as rate remained unchanged. Options would be undesirable, as it would only increase the cost base. It should be noted that same result is also possible with no cover. Volume 25,000, rate $1.01: No hedge:

When the rate moves favorably and volume remained unchanged, taking an options would cost extra money. However, if remained with no hedge, AIFS could enjoy the favorable exchange rate. AIFS should be very confident about the movement of exchange rate if it chooses this strategy. Volume 25,000, rate $1.22 (No impact),100% cover, 100% contracts Volume and rate remain as expected. 100% cover and 100% contracts is most attractive. It makes sense when rate remained unchanged and volume comes same as expected, having options will cost extra money. Volume 25,000, rate $1.48: 100% cover, 100% contracts

If the future rate moves to $1.48 and volume remained unchanged, options would cost more than futures contracts. In this case, maximum gain is only possible by having a 100% contract. Volume 30,000, rate $1.01: No hedge

This strategy falls on square 3 where the volume comes much higher than expected. The rate is out of the money and favorable to the AIFS. Additional money required due to unexpected increase in volume can be purchased from the market at $1.01. Both options and futures would increase the cost base. Volume 30,000, rate $1.22: 100% cover, 100% Contract

Here the rate remained unchanged. There is no bottom-line risk. This time volume came favorably. Options would obviously increase the cost base via premium. 100% cover with contract is no different from no hedge. However, to be safe it is ideal to take 100% cover with contracts. Volume 30,000, rate $1.48: 100% cover, 100% Contract

Volume is favorable. There is no volume risk. However, the bottom line risk is high. Contracts would yield much better result than options. The additional amount required has to be purchased from the market at a higher price. The increase in volume would help to offset the increase in bottom-line risk. This strategy falls to square 4 and this is a desirable strategy.

From the above, we can see that they should use different strategies to hedge risks under different circumstances. And exchange rate plays a very important role in deciding to use which hedging strategy. At this point exchange rate forecast does not show a very clear direction. According the US trade deficit, dollar exchange rate would be weaker in future. However, interest rate parity and fisher effect indicate that the US dollar would appreciate in the future. Thus, AISF should base their decision on additional market research and their experience. In actuality, using only contracts or only options is not recommended, because only contracts will cover the company only in one direction and only options will involve a lot of initial premium outlay which may make the hedging exercise very expensive. And the ideal strategy would be to have a mix of contracts and options. This can help balance the investments.

Recommendation for Action
As a result of AIFS’s activities and business model of bringing in revenues primarily denominated in USD, while at the same time incurring operating expenses in foreign currencies, the company is highly exposed to currency risk. Currency hedging is exactly what is needed in order to minimize the company’s degree of exposure to unfavorable shifts in the foreign exchange market. In this case, Tabaczynski put together scenarios for changes of two main unknowns –final sales volume and final exchange rates and Archer-Lock constructed the “AIFS Shifting Box”. Even with so much research, the solution doesn’t seem to be that straight-forward since there is different optimal choice under different scenarios. Just as Tabaczynski said in the discussion, “no matter how you hedge, half the time you win, half the time you lose”. Our team analysis has produced the following recommendation for future hedging according their aim: cover 100% of the expected requirements while keeping 100% contracts.

100% coverage is a policy of AIFS. This decision was made after the company experienced significant unexpected expense due to unfavorable currency exchange rates in 1995 which were only 80% hedged.. Based on the analysis, this is a sensible idea. Both contracts and options could be considered as insurances for international companies. As the charts in Exhibit 4 to Exhibit 7 showed, the rate movements of key currencies were not random walk and changed in a large range. In today’s highly volatile foreign exchange market, taking 100% cover on all currency exposures with various alternative hedging instruments reduces the uncertainty in the process and keeps risk in control as much as possible. Archer-lock commented on this policy as, “the key elements of the framework are that we cover 100% of the forecast and so do not speculate by leaving needs open at the pricing date”. As the analyzing hedging options spreadsheet shows the level of risk associated with changes in exchange rates, it becomes clear that given the business model of AIFS, currency hedging is entirely necessary. In short, we agree with this policy based on the former conclusions.

After we discussed the problem “to cover or not to cover”, balancing the proportion of options is very important. Each of the currency hedging possibilities has potential benefits and disadvantages. Forward currency contracts are especially useful and popular among importers and exporters who pay or receive payment in a foreign currency at some time in the future and relatively easy to implement. Contracts don’t have upfront premiums that must be paid, but can end up forcing AIFS to purchase currency as an unfavorable exchange rate. Options on the other hand do not need to be exercised but require a premium of 5% of the USD notional value. While options may be a more expensive solution, they are more secure. The major and common benefit is the certainty that organizations now have a fixed rate and cost to deal with, which will assist them in making informed business decisions.

Conclusion
In conclusion, AIFS’ business strategy presents unique challenges which must be managed in order to maximize the bottom line of the company. Bottom-line volume and competitive risk are factors that Tabaczynski and Archer-Lock must consider at all times when setting prices for the upcoming year. If they fail to account for any of the previously mentioned types of risk, the entire company is at risk of no longer operating as a going concern.

While volume and competitive risk are significant factors, the most important is the bottom-line risk due to the exchange rates. Having experienced unfavorable exchange rates severely impacting the business in the past, AIFS’ policy of 100% hedging carries benefits and risks. Although the company is taking steps to cover themselves completely given changes in exchange rates, there are potential downsides. While a forward or futures contract allows the company to accurately predict costs regardless of changes in the exchange rate, this may not be the best option. Should exchange rates change favorably, AIFS is still forced to complete the contract which would then be more expensive than simply exchanging currency at that date’s rate. Alternatively, while options give the right but not the obligations to exchange currency, there are also costs. The premiums for the options are due up front and will be paid regardless of the option being settled.

Overall, given AIFS’ model of revenues denominated primarily in USD while expenses are primarily in foreign currencies, it’s vitally important that the company hedge their risks. Most importantly, due to the fact that the company projects their costs out a year in advance, it’s even more important that they protect themselves from market changes. It is for this reason that we believe that their 100% hedging policy is the correct policy.

We can write a custom essay

According to Your Specific Requirements

Order an essay
Get Access To The Full Essay
icon
300+
Materials Daily
icon
100,000+ Subjects
2000+ Topics
icon
Free Plagiarism
Checker
icon
All Materials
are Cataloged Well

Sorry, but copying text is forbidden on this website. If you need this or any other sample, we can send it to you via email.

By clicking "SEND", you agree to our terms of service and privacy policy. We'll occasionally send you account related and promo emails.
Sorry, but only registered users have full access

How about getting this access
immediately?

Become a member

Your Answer Is Very Helpful For Us
Thank You A Lot!

logo

Emma Taylor

online

Hi there!
Would you like to get such a paper?
How about getting a customized one?

Can't find What you were Looking for?

Get access to our huge, continuously updated knowledge base

The next update will be in:
14 : 59 : 59
Become a Member