Essay About Currency Risk And Foreign Exchanges Rates

Hedging Currency Risk at Aifs
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Hedging Currency Risk at AIFSCase Synopsis: The American Institute for Foreign Study (AIFS) is a student exchange organization based in London. Through its companies, AIFS is responsible for sending 50,000 students on international exchanges annually with yearly revenues of about $200,000. In the U.S., the firm is split into two main divisions: College and High School Travel. Within these two partitions, AIFS sends a total of 25,000 students abroad: 5,000 in the College division and 20,000 in the High School division. Upon closer scrutiny, the College division produces higher margins than the High School division, which utilizes a volume-based low price strategy. In regards to financials, a majority of the firm’s revenues are received in US Dollars (USD), but costs are denominated in other currencies such as Pounds (GBP) and Euros (EUR). This gives significant risk to currency exposure at AIFS, emphasizing the necessity for foreign exchange hedging to reduce adverse impacts on profit. Elaborating on risks, another issue for AIFS includes their exposure to worldwide events due to being an international exchange organization. Sales could drop up to 60%, which would critically affect both the divisions, albeit High School more (low margins). The nature of AIFS’ business is catalog based – this means that prices are guaranteed and cannot be changed until the next catalog. This allows AIFS to build a strong and loyal customer following (mostly teachers) as they have completely eliminated any unexpected price changes through their catalog. This loyalty allows AIFS to charge higher prices in comparison to their competition (up to $200 more), but the price guarantee exposes AIFS to currency risk as world events may impact foreign exchanges rates. Therefore, AIFS’ costs will be impacted and they will be unable to respond appropriately. The two key players in AIFS are Christopher Archer Lock and Becky Tabaczynski. Christopher is the controller based in London, while Becky is the CFO based in Boston. The objectives of both Christopher and Becky align: their goal is to determine the optimal hedging strategy for AIFS to reduce risks for the firm.Analysis of the Issues: AIFS faces four primary risks: bottom line, volume, competitive pricing, and hedging strategy risk. Bottom line risk is the risk that an adverse change in exchange rates could increase the costs faced by AIFS. If the USD is weak to the Euro, AIFS will be forced to exchange at a higher rate, which will increase their costs and negatively affect their bottom line. If the USD is comparatively strong, AIFS can exchange favourably and positively affect their bottom-line. Hedging with forward/future or option contracts can decrease such bottom line risk. Volume risk is the risk that the estimated sales volume differs from the actual sales volume. Because AIFS must hedge before their sales cycle ends, the final amount of foreign currency is unknown. AIFS expects sales volume to be 25,000, which means that with a cost of €1,000 per person, a total of €25,000,000 will be required. AIFS hedges 100% of their costs. If final sales volume is higher/lower than projected, this could significantly affect AIFS’ bottom line depending on the hedging strategy chosen. If sales volume is lower or higher than expected, it means that AIFS either over-hedged or under-hedged. For instance, if actual sales volume ends up being less than expected e.g. 10,000 and AIFS hedged for 100% of 25,000, there will be excess sales volume 15,000 in EUR not needed by AIFS and will be reverse-exchanged at the spot rate back to USD, assuming AIFS has sufficient funds to fulfill the forward contract. This is unfavorable to AIFS because exchanging EUR back to USD depends on the future spot, creating variance. If the USD/EUR rate is out-of-money, AIFS would be in square 1 of the AIFS Shifting Box and would have to rely on options to minimize their losses. If the USD/EUR rate is in-the-money, then AIFS would use forward contracts over options as they are cheaper and would rely on the exchange rate gain to compensate for the lower sales volume. On the other hand, if AIFS hedged for 100% of 25,000, but actual volume ends up being 30,000, it means that AIFS under-hedged and the 5,000 excess volume will be naked and exposed to bottom line risk (foreign currency risk). If the USD/EUR exchange rate is out-of-money, AIFS will be in square 3 and short foreign currency. Since the exchange rate is out-of-money, they can purchase the volume required at a favorable spot rate.  However, if the exchange rate is in-the-money, then AIFS will have to purchase foreign currency at an unfavorable rate and rely on the sales increase to offset their losses. The third risk AIFS faces competitive pricing risk. Since pricing is set on a competitive basis, AIF cannot include the effects of transfer rate changes into price increases since this will drive demand down. Furthermore, hedging strategy risk is important to take into consideration when determining the best hedging strategy for AIFS.  Comments on Solutions and Strategies: Determining how to manage the aforementioned risks is essential when considering hedging strategies for AIFS. If no hedging strategy is used, transferring sales from USD to EUR would incur bottom line risk from fluctuating currencies. There are 3 situations – stable, weak, or strong dollar assuming volume of 25,000 (refer to Appendix E). A $6.5 million loss occurs with the weak dollar and a strong dollar will save $5.25 million. Provided there is sales volume risk as well, Tabaczynski’s spreadsheet shows that the nightmare scenario would be over-anticipated sales volume of 30,000 at a weak USD/EUR exchange rate, forcing AIFS to exchange USD at the naked spot rate, incurring a $7.8 million loss difference to the company’s bottom line. On the other hand, the best possible outcome for AIFS is if they do not hedge and the USD/EUR exchange rate strengthens to 1.01, generating a $6.3 million gain (See Appendix A). With her hedging strategy, forwards contracts have a strike price of $1.22 USD/EUR as forwards contracts incur no extra expense. The option strike price is also set to 1.22 USD/EUR as it is in their best interests to set the strike price as low as possible, because the option premium of 5% is a function of USD notional value, not risk. If she decides to cover 100% of the 25,000 sales volume with 100% options, she has the option to exercise the derivative at rates higher than 1.22. She will incur the option premium cost loss of $1.525 million on all exchange rates (See Appendix A), but only gain net $3.725 million at trading at spot exchange rates 1.01. With fluctuating volume, at 30,000 volumes, her nightmare scenario would be a $2.825 million loss and her maximum gain would be $4.775 million with a spread of $7.6 million (See Appendix D). Conversely, if she were to hedge 100% of her sales volume of 25,000 with 100% forwards, there would be $0 impact as she would generate the same revenue as her forecast leading to no difference in bottom-line profit. For all 3 predicted currencies (1.01, 1.22, 1.48) there will be a $0 value difference in company bottom line. (See Appendix A). This indicates the incremental cost of the forward rate higher than the spot rate ($0.00) that was paid to enter the forward. The nightmare scenario at unexpected volume 10,000 would incur a $3.15 million loss, and the best case scenario would be a $3.9 million gain with a spread of $7.05 million (See Appendix D). Provided that volume fluctuates from 10,000, 25,000 and 30,000 and that future currency fluctuates from 1.01, 1.22 and 1.48, the best combination of derivatives to hedge AIFS’s sales volume is a 100% cover with 50% in options and 50% in forward contracts. In this hedge, the nightmare scenario is a $2.062 million loss (down from a $2.825 million loss under 100% options, $3.15 million loss under 100% contracts) and the best case scenario is a $3.1375 million gain (down from a $4.775 million gain under 100% options, $3.9 million gain under 100% contracts) resulting in a min-max spread of $5.2 million (down from a $7.6 million under 100% options, $7.05 million under 100% forwards). Of all hedging combinations, this has lowest max gain and the lowest max loss and thus the smallest variance. We advocate the smallest min-max spread since the purpose of hedging is to protect bottom-line profit by having as little variance as possible through currency fluctuation, rather than seek to earn a profit through hedging.