Question

Hedging Currency Risk at AIFS The American Institute for Foreign Studies (AIFS) organizes study abroad programs and cultural Exchanges for American students. The firm's revenues are mainly in U.S. dollars, but most of its costs are in Eurodollars and British pounds. The company’s controllers review the hedging Activities of AIFS. AIFS has a hedging policy, but the controllers want to review the percentage Of exposure that is covered and the use of forward contracts and options. AIFS sets guaranteed Prices for its exchanges and tours a year in advance, before its final sales figures are known. The Controllers need to ensure that the company adequately hedges its foreign exchange exposure And achieves an appropriate balance between forward contracts and currency options.

Questions:

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

What criteria will be used to make a recommendation on a hedging strategy?

Answer 1

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

Answer: When implementing a hedging policy of 100% forward contracts, and if the volume of actual sales is 10,000 units, and the coverage percentage is 100%, then using forward contracts would not benefit AIFS because even though their costs are lower than anticipated, the company would still end up with €25,000,000 purchased out of which only €10 million are required, leaving €15 million unused. The same thing would happen at a 75% & 50% cover in which the unused portion of the currency purchased in the forward contract would be 8.75 and 2.5 million respectively. At a level of 25% cover, AIFS would be forced to purchase 3.75 million at the spot rate increasing their currency exposure. On the other hand, if the 100% forwards hedging policy is used and the actual sales are 30,000 units, AIFS would benefit from the favorable forward contracts terms, but would be faced with an increase in currency exposure due to the fact that there would be a need to purchase currency at spot rates to cover the deficit in funding. These unforeseen costs would add approximately $6 to $14 million in costs depending on the $1.01/1€, $1.2273/1€, or $1.48/1€ exchange rates used. In conclusion, this type of scenario would generate more revenue but could decrease/increase the company’s gross profit per unit depending on the spot rate used. If AIFS implements a hedging policy of 100% option contracts, with a volume of actual sales of 10,000 units, the three factors to consider are exchange rate, option premium fees, and cover level. If the exchange rate lowers to 1.01USD/1EUR and the options were negotiated at 1.2273USD/1EUR then the company paid more for what the liquid instrument is worth at the current market rate. On the other hand, if the exchange rate is 1.48USD/1EUR the company would be saving in costs because they purchased the needed currency to cover their cost base at a lower rate. Additionally, in this scenario, the company would simply let the remaining €15 million option expire and would not be burdened with unneeded currency. Again, at different cover percentages the company is not only concerned with option premiums but also with the spot rates. At a level of 10,000 the only cover level that would force AIFS to purchase currency at spot rates would be 25%. If AIFS implements a hedging policy of 100% option contracts, with a volume of actual sales of 30,000 units, and if the spot rate lowers to 1.01USD/1EUR and the options were negotiated at 1.2273USD/1EUR then the company paid more as in the 10,000 unit explanation above. The same thing would apply to a spot rate of 1.48USD/1EUR where the company would be saving up in costs because they purchased the needed currency at a lower rate. The difference between 10,000 units and 30,000 units is the fact that with 30,000 the company is required to purchase additional currency at spot rates, regarding of the cover level. This would in turn increase the currency exposure positively, neutrally, or negatively.

What Creteria will be used to make a recommendation on a hedging stategy?

Answer: Companies can be exposed to indirect risks through both business practices (such as contracting terms with customers) and market factors (for instance, changes in the competitive environment). When a snowmobile manufacturer in Canada hedged the foreign-exchange exposure of its supply costs, denominated in Canadian dollars, for example, the hedge successfully protected it from cost increases when the Canadian dollar rose against the US dollar. However, the costs for the company’s US competitors were in depreciating US dollars. The snowmobile maker’s net economic exposure to a rising Canadian dollar therefore came not just from higher manufacturing costs but also from lower sales as Canadian customers rushed to buy cheaper snowmobiles from competitors in the United States.