Hedging Currency Risks at AIFS (Case Study Analysis)

Introduction:
AIFS is a business which organizes educational and cultural flip programs throughout the world. This has two main divisions, The Study Abroad College Division and High School Travel Division AIFS receives revenues in US Dollars (USD), but incurred its costs in other currencies like Euros (EUR), that is why the business needs to hedge against currency rate fluctuation risk. AIFSs Business is catalog based and it grantees its customer that the price will never change till the publication of next catalog so AIFS is bound to keep fix catalog price for its customers for a specific period of time even there might be flections in currency rates.

Challenges:
There are three types of risks that AIFS is facing: Bottom-line Risk: An adverse change in exchange rates could increase the cost base. Tabaczynski explains that this movement can determine you out of the business. Volume risks : AIFS bought the foreign currency based on forecasted sales volumes, but in the moment, there might be some difference between projected sale and actual sale Competitive pricing risk: AIFS guaranteed that rate changes will have no effect affect price.

Instruments Being Used:

Two main instruments that AIFS is using to hedge the risk are: Forward Contracts Currency Options

The problem is that they have to do the hedging before sales. Archer-Lock (London-based controller for student exchange) and Becky Tabaczynski (CFO of groups high school travel division) are worrying about to know: What Expected Cost Should They Cover? In what proportions should AIFS use forward contracts and options?

Alternatives
Hedging Strategies:
Following are main Hedging Strategies that might be used for Hedging the risks No Hedging 100% Hedging with Forward Contracts 100% Hedging with Options

Exchange Rate Levels

Following exchange rate of dollar might be assumed while implementation of strategies Stable Dollar 1.22 USD/EUR Strong Dollar 1.01 USD/EUR Weak Dollar 1.48 USD/EUR

Analysis and Synthesis

No Hedging:
If the company does not hedge at all, it may have to face the risk. The fluctuation in exchange rate may affect the position of company either in positive or negative way. The Company expenses are in Euros and Ponds while revenues are in US Dollars (USD),There is a time period between agreement and payment. effect. The organization may benefit if the value of Euro increases. So, the organization will be able to increase their cost base, while their revenue in USD will still be the same. This may result in profits but if the value of Euro decreases, the organization will have less cost base and as a result, it may incur losses. Example Today (1.22 USD/EUR): Projected Revenue per Student: Projected cost per student Total Profit (USD) One Year Later, 1.48 USD/EUR Projected Revenue per Student: Projected cost per student Total Profit (USD) 1.01 USD/EUR Projected Revenue per Student: Projected cost per student Total Profit (USD)

USD 1,350 EUR 1,000 1,350 ( 1.22 x 1,000) = 130

USD 1,350 EUR 1,000 1,350 ( 1.48 x 1,000) =(- 130)

USD 1,350 EUR 1,000 1,350 ( 1.01 x 1,000) =340

No Hedging Sales 25000 Spot Price 1.22 USD Rate After 2 Cost Years Revenue(USD) (EU) Income Gain/Loss 1.22 33750000 30500000 3250000 1.48 33750000 37000000 3250000 -6500000 1.01 33750000 25250000 8500000 5250000

100 % Hedging with forward contracts & 100% Hedging with Futures:
If AIFS were to hedge against currency risk using 100% forward contracts, their position would be fully covered if they can accurately predict the amount and timing of the payments. If AIFS were to hedge using 100% options, they would be fully covered against currency risk, but would pay an option premium of $1,525,000 (30500000x5%)

According to our viewpoint both the contracts are beneficial in one or the other way, it only depends on the situations. both contracts have their pros and cons. If we take a variable fluctuations, then if fluctuations are high then its better to opt for option contracts to minimize our risk, but if fluctuations are lower than its better to go for forward contract as to save our 5% premium cost.

Decisions and Recommendations

If sales volumes are lower When the sales are low and the company is out of money, the company has an excess of currency. The option contract is more favourable in this situation.

When the sales are the low and the company is in the money, the forward contract is more favourable because option contracts costs more.

If sales volumes are higher When the sales are higher and the company is out of money, option contract is favourable because company has not to buy Euro at higher rate. When the sales are higher and the company is in money, the company loss is in difference on volume of sales and the increase of the exchange rates.

Favorable Hedging Decisions

We would advocate forward contracts as the gain is larger with forward contracts because it guarantees the amount of currency AIFS would pay receive and is exempted from paying 5% option premium. Moreover, it has maturity upto 1 year and sometimes longer. Hedging strategy may also work. In option strategy, we have to pay 5% premium. The forward contract is a good option as the company is limited on cash and May not able to pay advance premium.