Hedging Currency Risk at Aifs

Topics: Futures contract, Forward contract, Foreign exchange market Pages: 7 (2623 words) Published: November 5, 2010

AIFS is an American based company that offers travel abroad and exchange study services to both college and high school students. While AIFS’s revenues are denominated in American Dollars (USD), most of their costs are in foreign currencies as Euros (EUR) and British Pounds (GBP). Consequently, foreign exchange hedging has a crucial importance for the company because it provides protection against different types of risk that derive from its activity. In order to reduce risk, the company is using two hedging derivatives: forward contracts and put options to sell dollars. The aim of the paper is to determine an appropriate hedging policy which answers two main questions: how much to hedge, and in what proportions of forwards versus options. First, a description of the exposure of the company, particularly the three main risk factors: bottom-line risk, volume risk and competitive pricing risk is presented. Then, we set the “impact zero” scenario: sales volume of 25 000, a cost of 1000€ for every costumer and an exchange rate of USD 1,22/EUR. We consider three different exchange rate scenarios (weak, stable and strong dollar) and compare the costs for different alternatives of hedging. We further introduce the second risk factor, different sales volume, and reach the conclusion that the alternative that bares the minimum cost for the company is to hedge 75% of the costs using options in proportion of 75% and 25% forward contacts.

1.Currency exposure at AIFS
The currency exposure at AIFS is given by the nature of their operations. AIFS’s revenues are mostly in American dollars, while the company’s costs are in other currencies, such as Euros and British Pounds. The analysts of the company, Archer-Lock and Tabaczynski, projected a volume of sales for the next year of 25 000. The costs for each participant were calculated to be €1000, thus the total cost will reach €25 million. At a stable rate of the dollar against the euro of USD1,22/EUR , the total cost will be $30 500 000. As the profit depends on the total cost which is subject to change as dollar fluctuates, the company faces risks. Thus, the problem of the company is due to the mismatch between currencies. The main solution to overcome this problem is considered to be hedging using forward contracts and put options to sell Dollar and buy Euro. Since one of their policies is to keep prices fixed all around the year in dollars, while their costs are given in euros or other currencies, the firm encounters three main risk factors: the bottom-line risk, the volume risk and competitive pricing risk.

a)The bottom-line risk
This risk factor derives from the possibility of fluctuations in the future spot exchange rate. If, for instance, the euro appreciates against the dollar then the costs of the company will increase. Given that the prices are fixed in dollars, the company is going to encounter loss.

b)The volume risk
Since projected sales could differ from the actual sales, the company can register losses or gains. The main factor that can affect the projected sales is given by unexpected world events. This factor affects, in particular, the high school travel division because its customers react immediately at news of war or terrorism. At such news the sales could drop up to 60%. The 1986 terrorism acts, the Golf War in 1991, the attacks of 11 September 2001 and the Iraq War in 2003 are examples of events that can cause the sales to drop.

c)Competitive pricing risk
This risk factor is strongly connected with the company’s policy to keep the prices fixed for an entire year. This means that the adverse fluctuations in the exchange rate cannot be translated into increasing prices. On the other hand, this policy assures a competitive advantage in the market, more than 70% of the company’s sales come from loyal returning customers.

2.Consequences of not hedging
In order to reach a conclusion regarding whether or not it is necessary to hedge,...
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