Homework: Foreign Currency Transactions and Hedging – Hedging Currency Risk at AIFS
Case 1. What gives rise to the currency exposure at AIFS.
Currency exposure or currency risk is the type of risk that an individual or a company faces due to the fluctuation in price of one currency against another. For AIFS –a student exchange organization that offers education and travel programs all over the world- the fact that they do business domestically and internationally gives rise to several factors that exposes them to currency risk. The first, and perhaps most important factor is the fact that AIFS receives most of their revenues in US Dollar ($) but incurs costs in other currencies, primarily in Euro (€) or British Pound (£). This situation forces AIFS to manage liquid assets in different currencies which exposes them to the “bottom-line risk or the risk that an adverse change in exchange rates could increase the cost base.” In order to protect and manage this risk AIFS utilizes hedging contracts in the form of forward and option contracts, which are purchased at a minimum of 6 month prior price setting date for the current catalogue. Their business operations give way to another factor that accentuates their currency exposure. Because their hedging contracts start at least 6 months prior to the “main pricing date”, their sales volume and expense cover levels forecasted determines the type and the percentage of the hedging policy they implement. This is basically a “volume risk” because when they purchase currency based on a forecasted sales volume, there is a possibility that final sales would differ from those projected sales and the company would have to either purchase more currency at spot rates or perhaps incur in losses due to existing forwards contracts. Either of those two outcomes could erode AIFS’s profits. One last factor that exposes AIFS to currency risk is their “Price Guaranteed Policy”. This policy states that regardless of how the currencies fluctuate, positively or negatively, the company cannot modify their current catalogue prices. The main consequence from this type of price policy is that if the currency fluctuations and established hedging contracts don’t favor AIFS operations, they would not have a way to compensate or recuperate any losses incurred by modifying their pricing strategy, at least in the current catalogue period.
2. What would happen if Archer-Lock and Tabaczynski did not hedge? If Archer-Lock and Tabaczynski would not participate in any hedging contract, AIFS would be completely exposed to currency risk.
Setting their program prices 6 months prior to the catalogue date based on sales volume and expense projections, gives way to many uncertainties that could heavily impact positively or negatively their cost base, and in turn their gross profit and net income. For example, AIFS forecasted -based on past sales trends and new leads received from their loyal customer base- that five thousand students would be interested in traveling to Greece for summer studying programs. Based on this projection they determine their pricing strategy and release their catalogue with the price guaranteed policy stated on it. Then 2 weeks later the Greek financial crisis happens and the Euro price fluctuates downwards compared to the USD, and the forecasted sales volume is met. In this scenario, AIFS would positively benefit from the fact that their cost base is lower than projected for their actual sales volume, because their gross profit would be much higher than expected. On the other hand, if the scenario is exactly the same but instead of Greece is the UK and the British pound fluctuates upwards compared to the USD and the actual sales volume is as forecasted, then AIFS’ gross profit would be negatively impacted because the cost base for that volume of sales ais higher and the company is not able to modify their prices to compensate for the loss in gross profit.
3. 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. AIFS could benefit from deciding to use 100% forward contracts to hedge against currency risk if they could accurately predict the volume of sales and if the percentage of coverage projected is also 100%. If the forecasted sales of 25,000 units are actually sold and the company utilizes 100% forward contracts to cover 100% of their costs, they would incur in approximately $30,682,500 in total costs, including hedging costs. (See 100% Forward Contracts Spreadsheet). On the other hand, if actual sales remain the same 25,000 but AIFS decides a desired cover percentage of either 75%, 50%, or 25%, the company would be forced to purchase currency to cover their remaining costs of either 6.25, 12.5 or 18.75 million respectively at the spot rate of either $1.01/1€, $1.2273/1€, or $1.48/1€. These less than 100% coverage scenarios could in turn generate a higher currency exposure that could lead to significant gain, no extra profit or loss, or a substantial loss.
On the other hand, if AIFS decides to implement a hedging policy of 100% options at an actual sales volume of 25,000 units, the company would incur in total costs of approximately $32.2 million, including $1,534,125 of option premiums (See 100% Option Contracts Spreadsheet). This is roughly 1.5 million more than if hedging is done with 100% forward contracts. At the cover levels of 75%, 50% or 25%, using only option contracts would generate the same hedging costs -24.1 million, 16.1 million and 8.1 million- regardless of the $1.01/1€, $1.2273/1€, or $1.48/1€ exchange rates used (See 100% Option Contracts Spreadsheet). However, total costs would vary between $1.2 to $4.8 million depending on which spot rate applies when purchasing the currency deficit. This wide range of approximately $1.2 to $4.8 million exemplifies the currency exposure to which AIFS is exposed to at a lower than 100% cover level. Another factor to consider when studying the 100% option contract hedging policy is the 5% option premium paid at the desired cover percentage. As previously mentioned for the 100% cover the option premium is $1,534,125. At 75%, 50%, and 25% cover levels the option premium is approximately $1.2, 0.8, and 0.4 respectively. These option premium costs are an important factor because they can increase the total hedging cost and the actual total costs for AIFS. Note: All Excel Spreadsheets are attached at the end of this paper.
4. What happens to profits if the sales volumes are lower or higher than expected as outlined at the end of the case? When implementing a hedging policy of 100% forward contracts, and if the volume of actual sales is 10,000 units, and the coverage percentage is 100%, then using forward contracts would not benefit AIFS because even though their costs are lower than anticipated, the company would still end up with €25,000,000 purchased out of which only €10 million are required, leaving €15 million unused. The same thing would happen at a 75% & 50% cover in which the unused portion of the currency purchased in the forward contract would be 8.75 and 2.5 million respectively. At a level of 25% cover, AIFS would be forced to purchase 3.75 million at the spot rate increasing their currency exposure (See Zero Impact Scenario: 25K Sales Unit Spreadsheet). On the other hand, if the 100% forwards hedging policy is used and the actual sales are 30,000 units, AIFS would benefit from the favorable forward contracts terms, but would be faced with an increase in currency exposure due to the fact that there would be a need to purchase currency at spot rates to cover the deficit in funding. These unforeseen costs would add approximately $6 to $14 million in costs depending on the $1.01/1€, $1.2273/1€, or $1.48/1€ exchange rates used (See Summary Scenario Spreadsheet). In conclusion, this type of scenario would generate more revenue but could decrease/increase the company’s gross profit per unit depending on the spot rate used. If AIFS implements a hedging policy of 100% option contracts, with a volume of actual sales of 10,000 units, the three factors to consider are exchange rate, option premium fees, and cover level. If the exchange rate lowers to 1.01USD/1EUR and the options were negotiated at 1.2273USD/1EUR then the company paid more for what the liquid instrument is worth at the current market rate. On the other hand, if the exchange rate is 1.48USD/1EUR the company would be saving in costs because they purchased the needed currency to cover their cost base at a lower rate. Additionally, in this scenario, the company would simply let the remaining €15 million option expire and would not be burdened with unneeded currency. Again, at different cover percentages the company is not only concerned with option premiums but also with the spot rates. At a level of 10,000 the only cover level that would force AIFS to purchase currency at spot rates would be 25%. If AIFS implements a hedging policy of 100% option contracts, with a volume of actual sales of 30,000 units, and if the spot rate lowers to 1.01USD/1EUR and the options were negotiated at 1.2273USD/1EUR then the company paid more as in the 10,000 unit explanation above. The same thing would apply to a spot rate of 1.48USD/1EUR where the company would be saving up in costs because they purchased the needed currency at a lower rate. The difference between 10,000 units and 30,000 units is the fact that with 30,000 the company is required to purchase additional currency at spot rates, regarding of the cover level. This would in turn increase the currency exposure positively, neutrally, or negatively.
5. What hedging decision would you advocate?
In this scenario is not easy to determine which is the best case scenario due to the many variables to take into consideration. However, I advocate for a 75% forward contracts and 25% option contracts for a projected sales volume of 25,000 units, and a cover percentage of 100%. I consider it a happy medium. As shown in the “Zero Impact Scenario: 25,000 Sales Units” spreadsheet, the total costs incurred (at any given exchange rate) are lower than any percentage combination, except for 100% options. What makes this better that the 100% forward contracts is that it spreads the currency risk and allows to make up for negative trends in the market. For example, if the actual sales are less than projected, AIFS would not be left with so much unused currency, because it can let the options expire. Additionally this option is the one where the lowest option premium is paid. These two factors would in turn benefit the cost base.
