Currency Hedging at Aifs

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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...
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