Get instant access to this case solution for only $19

Hedging Currency Risk at AIFS Case Solution

Solution Id Length Case Author Case Publisher
756 1298 Words (3 Pages) Mihir A. Desai, Anders Sjoman, Vincent Dessain Harvard Business School : 205026
This solution includes: A Word File A Word File and An Excel File An Excel File

AIFS is an American company that international exchange opportunities to both college and high school students. While the company’s revenues are generated in American Dollars (USD), a large proportion of their costs are incurred foreign currencies such as Euros (EUR) and British Pounds (GBP). Moreover, the company provides a guarantee that it will not change its prices that are announced in advance. Therefore, foreign exchange hedging is important to mitigate the currency risk of AIFS. The company has two alternatives to hedge its currency risk: forward contracts and currency options. The essay determines the approximate cost of each alternative and elaborates the reasons for the difference. A further attempt is made to outline the scenarios in which each alternative will be more advantageous. In the end, possible consequences of an increase or decrease in projected sales are outlined.

Following questions are answered in this case study solution:

  1.  What gives rise to the currency exposure at AIFS?

  2. What would happen if Archer-Lock and Tabaczynski did not hedge at all?

  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.

  4.   What happens if sales volumes are lower or higher than expected as outlined at the end of the case?

Screenshot-51561632313.png

Hedging Currency Risk at AIFS Case Analysis

1. What gives rise to the currency exposure at AIFS?

The AIFS has two separate programs: a semester-long program for college students, and a similar program for high school students. These students are sent to various countries – including the UK and other European countries – to complete an educational or cultural exchange program. These students originate from the US and pay for the cost of the program is US dollars. Therefore, the revenues of AIFS are collected in the US dollars. On the other hand, a majority of the expenditure related to the program is incurred in the currency of the areas where they are sent. Thereby, for students that go to Europe, the costs are likely to be incurred in Pounds or Euros. Therefore, a change in the exchange rate between USD and GBP or between USD and EUR could lead to a mismatch between revenues and costs. For instant, a depreciation of US dollar relative to Pounds to Euros may lead to higher costs in US dollar terms. Moreover, the problem is further exacerbated by the fact that the company gives a guarantee that the prices will not change from the level previously announced. Since the option to adjust prices in response to exchange rate changes is not present, the company’s only recourse to minimize variations resulting from changes in exchange rate is to hedge its foreign currency risk.

2. What would happen if Archer-Lock and Tabaczynski did not hedge at all? 

If the company does not involve in hedging, it will be exposed to foreign currency risk – the unexpected movements in foreign currencies. The cost for the exchange students is incurred in foreign currencies such as Pounds and Euros while the revenues are generated in US dollars. A depreciation of the local currency will lead to higher cost in local currency terms, while an appreciation of the local currency will lead to lower cost in local currency terms. Therefore, the net effect of an unhedged position could be both positive and negative. While these exchange rate gains and losses may cancel each other over long-term, the short-term variations in profits may not be desirable. To determine the magnitude of the change in cost that can be caused by fluctuations in exchange rate, let us look at the data provided in the case.

 

Demand (Units)

Price (Euros)

Spot Rate (USD/EUR)

Total Cost (USD)

Normal Scenario

25,000

 1,000

1.22

30,500,000

Dollar Appreciation

25,000

 1,000

1.01

25,250,000

Dollar Depreciation

25,000

 1,000

1.48

37,000,000

Under the current scenario, where the demand is for 25000 students and the spot rate is USD 1.22 / EUR, the total cost incurred by the company is expected to be $30.5 million. If the currency risk in not hedged, exchange rate appreciation to USD 1.01 /EUR could decrease the dollar cost to $25.25 million. On the other hand, exchange rate depreciation to USD 1.48 / EUR could increase the cost to $37 million.

3. What would happen with a 100% hedge with forwards? A100% 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?

The ‘zero impact’ scenario, with expected sales volume of 25000 and an exchange rate of USD 1.22 / EUR, results in a total cost of $30.5 million. The total cost will drop to $25.25 million if the exchange rate is lower (USD 1.01 / EUR), and increase to $37 million if the exchange rate is higher (USD 1.48 / EUR). The following table illustrates how these costs will change if all of the currency risk is hedged using the two different proposed methods:

Total Cost Under Different Hedging Alternatives

Exchange Rate (USD/EUR)

1.01

1.22

1.48

Forward Hedging:

 

 

 

Cost Without Hedging

25,250,000

30,500,000

37,000,000

Gain/(Loss) from Forward Hedging

(5,395,000)

(145,000)

6,355,000

Net Cost After Hedging

30,645,000

30,645,000

30,645,000

Option Hedging

 

 

 

Cost Without Hedging

25,250,000

30,500,000

37,000,000

Gain/(Loss) from Option Hedging

(1,525,000)

(1,525,000)

4,975,000

Net Cost After Hedging

 26,775,000

32,025,000

32,025,000

 

 

 

 

 

 

Hedging with forward contract has minimal impact on the total cost under the various exchange rates. The net cost after hedging is slightly different from the cost before hedging because the forward rate (USD 1.2258 / EUR) is slightly different from the current spot rate (USD 1.22 / EUR). When the US dollar depreciates, the futures contract will allow the company to pay a lower exchange rate and the impact of higher cost will be mitigated. Similarly, when the US dollar depreciates, the forward contract will compel the company to pay a higher exchange rate and the net cost after hedging will increase. The net impact of the hedging will be such that the total cost after hedging will always remain $30.645 million. In the case of hedging with options, the options will expire worthless if the exchange stays the same or appreciates. In these cases, the only additional cost will be the cost of purchasing the options, which is $1.525 million. If the exchange rate depreciates, the in-the-money options will be exercised, resulting in a net gain of $4.975 million. The impact of the net gain or loss on options will be such that the total cost after hedging will be $32.025 million if the exchange rate remains the same or depreciates. It is interesting to note that this cost in higher than the cost incurred under hedging with forward contract. However, the total cost after option hedging is lower than the total cost after forward hedging if the exchange rates appreciate. This is because the options give the company to not exercise the options if they are out-of-money.

4. What happens if sales volumes are lower or higher than expected as outlined at the end of the case?

If the sales are different from expected, the optimum hedging strategy will depend on the direction that exchange rates take. If the sales turn out to be lower lower and the exchange rate also appreciate, the forward contract can magnify the impact by costing extra money for the company. The currency options will be more suited in this case because the company can choose against exercising the out-of-money options. However, if the sales are lower and the exchange rate depreciates, the company might be able to reap greater benefits from the forward contract because they are cheaper than the currency options.

Get instant access to this case solution for only $19

Get Instant Access to This Case Solution for Only $19

Standard Price

$25

Save $6 on your purchase

-$6

Amount to Pay

$19

Different Requirements? Order a Custom Solution

Calculate the Price

Approximately ~ 1 page(s)

Total Price

$0

Get More Out of This

Our essay writing services are the best in the world. If you are in search of a professional essay writer, place your order on our website.

Essay Writing Service
whatsapp chat icon

Hi there !

We are here to help. Chat with us on WhatsApp for any queries.

close icon