Currency Hedging at Aifs

Q1. What gives rise to the currency exposure at AIFS?

* Currency exposure is the extent to which the future cash flows of an enterprise, arising from domestic and foreign currency denominated transactions involving assets and liabilities, and generating revenues and expenses, are susceptible to variations in foreign currency exchange rates. * AIFS organizes educational and cultural exchange programs throughout the world. AIFS receives most of its currencies in American dollars (USD but it incurs costs in other currencies mainly in Euros (EUR) and Pounds (GBP). * AIFS hedged its future cost commitments up to 2 years in advance. The problem was that the hedge had to be put in place before AIFS had completed its sales cycle, and before it knew exactly how much foreign currency it needed.

* A key feature was that AIFS guaranteed that its prices would not change before the next catalog, even if world events altered AIFS’ cost base. * According to AIFS’s hedging policies, it has to predict the exchange rate fluctuation, the number of customers, which may be different with the final exchange rate and the volume when selling currencies, so the currency exposure happens. The actions of AIFS’s competitors may make AIFS less competitive resulting in minimum sales of the currencies bought, further resulting in currency exposure. So the bottom-line risk, the volume risk and the competitive pricing risk will give rise to the currency exposure at AIFS.

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Q2. What would happen if Archer-Lock and Tabaczynski did not hedge at all?

* AIFS organizes educational and cultural exchange programs throughout the world. * It has two major divisions: The Study Abroad College and the High School Travel division. Both are managed by Archer-Lock & Tabaczynski respectively. * AIFS receives most of its currencies in American dollars (USD but it incurs costs in other currencies mainly in Euros (EUR) and Pounds (GBP). AIFS hedged its future cost commitments up to 2 years in advance. The problem was that the hedge had to be put in place before AIFS had completed its sales cycle, and before it knew exactly how much foreign currency it needed.

* Therefore, for AIFS, the foreign exchange hedging is the key important area. The managers use currency hedging to protect their bottom line and cope with changes in exchange rates. But if Archer-Lock and Tabaczynski did not hedge at all, it would mean full exposure to the currency risk, the company could lose a lot of money if USD depreciated i.e weak dollar. * The company could yield good results and profit when the USD appreciated and if they did not hedge at all, as there are no other losses to erase their total revenue.

* However, they cannot know what the future sales volume and future exchange rate are, and so they may need to face a tremendous loss of money if USD depreciated. The cost base of the company would increase, and the revenues in USD will remain the same, this means their profitability would be erased. Also, AIFS needs to preserve their price guarantee policy. If they did not hedge at all, the company may incur losses by following this policy. * Moreover, there may be a difference between final sales volumes and projected sales volume, and this exposes the company to having either more or less of the foreign currency depending on the final sales volume.

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Q3. What would happen with a 100% hedge with forwards? A 100% hedge with options? Use the forecast final sales volume of 25,000 and analyze the possible outcomes relative to the ‘zero impact’ scenario described in the case. Complete the spreadsheet.

* Refer sheet “100% Forward” of the attached excel in Annexure. It shows the Cost that would be incurred with 100% hedge using Forward contracts for different scenarios. When currency rate is $1.01, the actual cost incurred is less than the forecasted total cost. Hence, there is a gain for AIFS. But for currency rate $1.22 & $1.44, it’s a loss & there is risk.

* Refer sheet “100% Options” of the attached excel. It shows the Cost that would be incurred with 100% hedge using Options for different scenarios. When currency rate is $1.01, the actual cost incurred is less than the forecasted total cost. Hence, there is a gain for AIFS. When currency rate is $1.22, the actual cost incurred is same as the forecasted total cost. Hence, there is no gain or loss for AIFS. But for currency rate $1.44, it’s a loss & there is risk.

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Q4. What happens if sales volumes are lower or higher than expected as outlined at the end of the case?

* Refer sheet “10000 Sales” for cost incurred and Gain/loss for AIFS for different scenarios and actual sales volume of 10000. * Refer sheet “25000 Sales” for cost incurred and Gain/loss for AIFS for different scenarios and actual sales volume of 25000. * Refer sheet “30000 Sales” for cost incurred and Gain/loss for AIFS for different scenarios and actual sales volume of 30000.

* There will be 4 outcomes with the ‘in the money’ and ‘out of money’ positions and high and low sales volume (30000 or 10000). * Square 1 shows low sales volume (10000) with strong USD that when the company is out of money (1.01USD/EUR). AIFS has an excess of currency. In this case, if it locked into surplus forward contracts then it would lose money. So the option contract is more favorable. AIFS does not execute the contract, it just lets it expire.

* In square 2 shows low sales volume (10000) with weak USD, The requirement of the currency is below the projection (25000), and the exchange rate is high (1.48USD/EUR). If AIFS uses forward contract the gain is larger compared to when it uses options contract because the options contract costs 5% of the nominal USD strike price. * In square 3 the exchange rate moved out of money (1.01USD/EUR) and the sales go higher (30000) than expected. So AIFS doesn’t have to buy euro at higher rate, therefore, the Options contract is better, as the extra volume they need (5000), can be bought at the spot rate. The increase of the Spot and Fixed rates and the difference of the volume of sales are the reason for company loss.

* The tricky square 4 shows when the exchange rate moved in the money (1.48 USD/EUR) and AIFS’s sales volume came in higher (30000) than projections, which means the company need more currency (5000), however, the exchange rate is high. In this case, Forward contracts should be used and the extra volume at the spot rates should be bought. The increase of sales may offset the downside.

* For companies that work with more than one currency, several hedging techniques are available to guard against foreign exchange fluctuations. After studying and addressing the case study of AIFS, it can be concluded that the changes in fees can be the cause to currency exposure. The fact that the company’s revenues are in USD, and costs in GBP and Euro’s may result in a rise to currency exposure.

After analyzing the affects of financial instruments such as forward and option contracts will have on the company, it has been decided that the company would be at a better advantage with Forward contract in order to prevent risks. AIFS charges USD by “catalogue-based” prices from its customer, and as the company guaranteed the prices will not change, if the rate of the USD decreases then the company will be at a loss as they will have to cover other expenses with the currency they have bought, and in order to prevent this risk, the company would be in a better position if they hedged.

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Q5. What hedging decision would you advocate?

* For companies that work with more than one currency, several hedging techniques are available to guard against foreign exchange fluctuations. After studying and addressing the case study of AIFS, it can be concluded that the changes in fees can be the cause to currency exposure. As AIFS guaranteed its prices would not change before the next catalogue, if the USD goes weak, AIFS need to more USD to pay for its overseas cost¸ however the price cannot be changed, which means AIFS will lose money. To eliminate this risk, AIFS better hedge.

* Hedge with Forward Contract:

The forward contract can guarantee the amount of currency AIFS would receive in the expiry date of the contract, so it can get larger profits with forward contracts if AIFS counts on a favorable exchange rate. The company can also avoid the 5% option premium, but it is not easy to get the counter party who would agree to fix the time period and the future exchange rate which would result in illiquidity. Thus being bilateral private contracts, the forwards have to be executed.

* Hedge with Options:

The Option contract can eliminate the downside risk and being more flexible, it can be seen as a combination of covered interest arbitrage depending on the difference in currency options and interest rates; it gives the company the right to sell or purchase a currency at an agreed exchange rate, but not the obligation. With the option contracts AIFS can hold the currency until the favorable exchange rate arises, so it would be more secure for the company. However, the premium cost is the disadvantage of option, and it has to be paid up front.

* Both forward contract and option contact work if the company is tight on cash and cannot spend 5% option premium – in this case the forwards contract is a better choice. However, if AIFS has sufficient funds and foresees changes in exchange rates, then it should use option. AIFS does not have to exercise the contract when currency moves to unfavorable exchange rates.