Hedging Currency Risks at AIFS Essay

The American Institute for Foreign Study (AIFS) is offering cultural sub programs for American students and High School pupils throughout the world. Their customers have the possibility to go oversea while the AIFS organises the whole trip for them. Due to their business model the revenues of the federation are denominated scarce in USD, since the offer is for American students who pay in USD. Meanwhile the costs of the connection is mostly denominated in strange capital because AIFS has to pay the transport, the hotel and much more in the countries in which their customers are travelling, accordingly the satisfying has to pay in the local specie of these countries.In result of the fluctuating exchange rate of USD against foreign currencies and the fact that AIFS fixes the price for their service before the costs can be estimated, the firm faces an inevi sidestep bills impression. In order to limit or eliminate this risk, AIFS has to hedge their currency exposure. At th e moment the comp some(prenominal) hedges vitamin C% of their exposure using away contracts and currency options. Now Becky Tabaczynski, CFO of wholeness of the main divisions, is creating a model, including opposite scenarios, with the goal of identifying which proportion of the exposure should be hedged at both and in which proportion send on contracts and currency options should be used for hedge. non hedging at all could have disastrous consequences for the whole accompany because in the boldness of a weak long horse the costs could lift drastically while the revenues remain fixed. Suppose the company has fixed the prices for the genuine season and now the costs in Europe are one meg euros, while the exchange rate is at 1.20 USD/EUR. This operator the firms costs are 1.2 million dollar. If the dollar weakens against the euro and the exchange rank rises to 1.32 USD/EUR, costs for AIFS would growth by 10%. Thus costs would increase by The higher the costs turn out, the higher this negative raise would be in nominal amount. The biggest stake of the costs are in euro and pound sterling, hence these two currencies are of major concern. In campaign of a strong dollar the company would profit the most without hedging except due to the downside trend of the dollar against euro and sterling simultaneously in short and medium term (Exhibit 6 & 7) thither is healthy show up that AIFS should be prepared to cover their currency exposure.If the company would use vitamin C% forward contracts to hedge their costs, they would fix the costs, no matter what happens to the exchange pass judgment of dollar to foreign currencies. An advantage of this strategy is that AIFS does non have to oblige any costs entering the forward contracts, scarce on the early(a) hand, it will neither make a profit in font the dollar strengthens nor will it suffer a loss in slickness the dollar weakens. A more flexible but meanwhile more expensive strategy to hedge is o nly using currency options. That means AIFS would have to pay the option reward in any drive but this strategy allows to profit from unlimited favourable movements while modification losses by the premium. So if the view rate at decease is higher than the strike price, AIFS can exercise their option and misdirect foreign currency for the lower strike price. And if the stead rate at outcome is less than the strike price, AIFS can forget about the option and buy for the lower imperfection rate. In any showcase the option premium has to be added to the costs. The possible outcomes in the two described strategies and a scenario with no hedge at all are summarized in the table below.% teetotum100%100%0%Contracts0%100%Options100%0%1.01-3,725,0000-5,250,0001.221,525,000001.481,525,00006,500,000The table is based on a sales volume of 25,000 and average cost of 1,000 per participant. That means, with the current spot rate of 1.22 USD/EUR the costs would be $30,500,000 (25,000,000 * 1.22 USD/EUR). The option premium in this case is 5% of the USD nonional value that is hedged and three scenarios are examinedThe dollar strengthens (1.01 USD/EUR)The dollar remains stable (1.22 USD/EUR)The dollar weakens (1.48 USD/EUR)In the first column the proportion of the hedged amount is given and in the second and ternion column of the table the proportions of forward contracts and currency options used to hedge are listed respectively. The fourth fifthand sixth column show the nominal heart and soul on the costs in each scenario relative to the zero jolt scenario (exchange rate remains stable at 1.22 USD/EUR) while it is assumed that in each hedging strategy the strike price is the current spot rate of 1.22 USD/EUR. Comparing the results of the table shows the advantages and disadvantages of each strategy. If 100% of the currency exposure is hedged only using options, the costs rise by $1,525,000 (which is only the option premium $30,500,000 * 5%) both in the zero re late scenario and in the scenario of 1.48 USD/EUR, since in both cases the option will be exercised.In the case of a strong dollar (1.01 USD/EUR) the option will not be exercised since euros can be bought to the lower spot rate but the premium is lost. In total the costs still sink by 3,725,000 because the effect of the lower spot rate compensates the premium. Using only forward contracts to hedge results into no come to on the costs in any case since the exchange rate is fixed no matter what happens and there is no initial cost entering the contract. In case AIFS does not hedge at all, the costs either decrease by $5,250,000 if the exchange rate is 1.01 USD/EUR, or remain unchanged in the zero impact scenario or increase by $6,500,000 if the exchange rate is 1.48 USD/EUR. The impact on the cost if nothing is hedged arises merely from the difference in the spot rate and is much stronger than in the hedged case.Since the company is highly touched by news of war, terrorism and politi cal instability, events which are impossible to predict, I would suggest to alter their hedging policy and use mainly options for hedging. In case of such terrible news the forecasted volume of 25 gravitational constant could drop up to 60%. That means in the worst case of a 60% drop, the companies costs decrease by 15 million euros but AIFS would be obliged to buy this amount if they are only hedged with forwards. Options instead would give the company more flexibility, which is a major issue since not only the exchange rates fluctuate but also the volume of participants. In my opinion AIFS should use proportions of 75% options and 25% forward contracts. In this way AIFS would fix the costs for a rear of their exposure and still be flexible enough to react to diametrical market circumstances and unforeseen events.Moreover AIFS should keep covering 100% of their exposure because they have already experienced a loss of $700,000 in 1995 while they only hedged 80%. In addition the c ompany should continue to deal with 6 unlike banks to reduce the counterpart risk. In the following table the impact on the costs in different scenarios are summarized using the same methodology as in the table above.In the worst case scenario with 10,000 participants and in the scenario with 30,000 participants the currency exposure decreases to 10 million and increases to 30 million respectively but the impact on the costs using different proportions of forward contracts and options remains the same relatively speaking.Instead of derivatives, an alternative possibility for AIFS to hedge their currency exposure would be to set up accounts abroad in foreign currency up to a certain amount. This would simplify the hedging approach and it would be reasonable the business model of AIFS forces them to keep foreign exchange every year.