Option contracts on the other hand give AIFS much more flexibility. If they future spot rate is lower than the option strike price, AIFS can cancel their option and buy Euros at the lower rate. AIFS must still pay the option premium though, currently 5% of the USD amount hedged. Unfortunately for AIFS their profit margin is only around 5%, so hedging completely with options could wipe out any profit.
We chose the 75%/25% forward/option mix because it provides us with the lowest cost assuming 100% coverage, and that we can not invest in solely forwards or options. We understand that our margins are low and that any money we can save is crucial to our success. Another reason 75% forwards would work out favorably for AIFS is because of the cost savings they can achieve due to economies of scale. By that, we mean that they can achieve discounts of cumulative hedging in the form of futures contracts. Finally we like the fact that if the forward contracts were out-of-the-money than we would be able to obtain currency at the more favorable spot price. Conversely, if the forward contracts were in-the-money, than AIFS already has their favorable rate and must only buy more for added volume that was not predicted. This scenario effectively eliminates Volume risk.
The risk that we leave ourselves exposed to in this scenario is that of the forward contracts. If they come in out-of-the money than we will be paying significantly higher costs than our competitors. In other words, if the strike price associated with the forward contracts is higher than the future spot rate, we stand to lose money. Still we would recommend that AIFS be more hedged in forwards, and exposed to this risk, than to be hedged more in options. As we wrote earlier, option premiums of 5% could wipe out any operating profits. AIFS is not in the business of speculating on future foreign exchange rate movements, rather they want to maintain stable cash flows. Hedging at a 75%/25% forward/option...
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