Hedging Currency Risks at Aifs – Report
MID TERM EXAMINATION – Financial Risk Management TERM III, NMP-28, November 2015 Open Book Exam. All material except phones and laptops allowed.Sharing of material not allowed. Time: 2 1/2 hrs Maximum Marks: 30Refer to the case study ‘Hedging Currency Risks at AIFS’ and answer the following questions.Enumerate the risks faced by AIFS as a result of the business model it has adopted. Are there any risk mitigation methods AIFS can adopt to hedge partially or fully any of these risks before it turns to using financial derivatives for the purpose? (2 marks)Ans: Key points: Bottom line risk because of costs being in EUR (foreign currency); Sales volume risk – this is a risk because not only does it mean variance from planned volume and revenue but enhances the exchange rate risk and makes the hedging less beneficial and more risky than it normally can be; competition and fixed price – prevents a natural hedge which could have been the case if any price rise could be transferred to customers. Others being geo-political risk, which induces the sales volume variability.Possible risk mitigants: Many of you have mentioned what AIFS ‘can do’ in future e.g. have a reverse flow of students, open a forex account, etc. Reverse flow is already there in some form in the Au Pair program if you notice (Though this might help in a minimal manner); yes, they can build a larger business in this direction. How can a forex account help since they have no inflows in forex at the moment? Other possible methods mentioned are price flexibility, better sales prediction using analytics, etc.
What is the functional currency for AIFS? What type of positions (short or long on USD or EUR) can AIFS take with forward contracts and options if it uses these to hedge the currency exposure? (2 marks)Ans: Functional currency is USD. And it is not because revenues are earned in USD. For most Indian IT companies, maximum revenues come in USD. Does that make it their functional currency? Ways to hedge are: Going long forwards or futures on EUR or GBP; going short forwards on USD; going long calls on EUR or GBP; going long puts on USD. In currency hedging it is important to mention which currency you’re taking a position in. Just saying taking a long position is not enough.The following matrix has been created on the lines of Exhibit 9 in the case. Complete the matrix for the combinations given assuming volume of 25,000:Payout: Total costPayoff: Economic profit/ loss% cover of whichSpot USD/EUR exchange rates after 2 yearsForwardsOptions1.051.201.51.051.201.5Case 10 26.2530 37.5 000Case 2751000 29.063031.88(2.81)05.62Case 3755050 28.2230.5632.44(1.97)(0.56)5.06Case 4750100 27.3831.12533(1.125)(1.125)4.50Case 51001000 303030(3.75)07.50Case 61005050 28.87530.7530.75(2.625)(0.75)6.75Case 71000100 27.7531.531.5(1.5)(1.5)6.0