Hedging Currency Risk at AIFS

Hedging Currency Risk at AIFS: Assignment questions: Q. What gives rise to the currency exposure at AIFS? A. AIFS is a company that specializes in providing educational and cultural exchange programs for college and high school students. Overall the company provides services to approximately 50,000 students each year, and has revenues of about $200,000,000. In the assigned case, we study two divisions of AIFS; a College division, a High School Travel Division, and the possible consequences to AIFS’s business exposure with respect to the fluctuations in foreign currency values and other factors. The College division and the High School Travel Division, service approximately 25,000 US students with the bulk of the students traveling to Europe or the United Kingdom. AIFS provides a catalog where one could chose the study-exchange program of one’s choice (with approximately 35, 000 different prices).The pricing for the College division was based on an academic planning year, from July 1 to June 30 – (summer, and Fall/Spring catalog). The High School Travel Division pricing was organized on a calendar year basis running from January to December (Fall Catalog). In addition, AIFS had a guaranteed price policy - in other words; prices would not change before the next catalog was sent out.

The College division (CSS) had about 5,000 students, was more profitable, and its profits were less susceptible to overseas political instability (war, terrorism) than was the High School Travel Division (ACIS). The ACIS had 20,000 students, was less profitable, but had a greater volume of students. Because ACIS cliental were primarily composed of high school students, any overseas political instability could be quite detrimental to the company bottom line (as much as 60%) as was demonstrated during the following world events: 1. The 1986 terrorism acts (Paris, Stockholm, and Germany). 2. The 1991 Gulf war. 3. The 2001 September 11 terrorist attacks. 4. The 2003 Iraq War. Since AIFS was (is) involved in international trade (traveling exchange students), profits were always going to be affected by currency movements, but overseas political events could dramatically reduce profits even more than if the company make a poor currency hedge decision. Furthermore, AIFS has competitors, so if their competition hedges and AIFS does not, AIFS could find itself in a poor competitive position. Now, AIFS is paid in USD’s thus the currency that requires protection is the USD. Obviously if there is a great deal of volatility in the currency market and if the value of the USD drops vs. the pound or euro, AIFS’s buying power will decreased, as will its bottom line. So we buy euro calls.

Q. What would happen if Archer-Lock and Tabaczynski did not hedge at all? A. The table below demonstrates three different outcomes if AIFS did not hedge its currency positions. If Dollar Remains Stable

$1.22

$1.22 * 25,000,000 UNITS EURO

$30,500,000.00

Cost Per Student (@$1.22, or $1,220 per student is company projected cost)

$1,220.00

If Dollar Becomes Weak

$1.48

What I Actually Pay For Euros @ $1.22 and $1.28

$37,000,000

Cost Per Student

$1,480.00

If Dollar Becomes Strong

1.01

What I Actually Pay For Euros @ $1.01 and $1.28

$25,250,000

Cost Per Student

$1,010.00

As can be seen from the above table, three different outcomes would be produced from the given case data. AIFS projected its costs at $1,220 per student, or $1.22 times 1000 euros. Thus, if the value of the euro went down the company would have a windfall, and they would lose money if the euro went above the $1.22 mark. Q. What would happen with a 100% hedge with forwards? A. With a 100% forward hedge the cost is known. It would be $1.22 per euro, or $1,220 cost per student. Q. 100% hedge with options? In case A, if the dollar remained @ $1.22, the cost to protect, or hedge its position would cost AIFS $1,525,000.00 or $30,500,000 + $1,525,000 = total cost of $32,025,000 In case B, the best case, if AIFS hedged at $1.22 (the strike price) at a cost of 105% ($1.28) and the cost of the euro declined to $1.01 then AIFS would benefit due to greater buying power of the dollar vs the euro. In this case we recall that AIFS projected company cost was $1.22 per euro. AIFS paid $1,525,000.00 to obtain this option which they will not exercise, and will buy the euro on the open market instead. AIFS incurred a cost of $1,525,000.00 when they purchased this option.

Thus the windfall to AIFS due to the decline in the euro is: Buy euro on open market @ $1.01 x 25,000,000 units = $25,250,000 The base cost is $30,500,000 AIFS windfall is $30,500,000 - $25,250,000 = $5,250,000 less the $1,525,000 paid for the option. AIFS improved its profit position by $3,725,000.

In case C, the option call went into the money. Exercise option - buy euro @ $1.22 x 25,000,000 units = $30,500,000 The base cost is $30,500,000 AIFS cost is $30,500,000 + $1,525,000 paid for the option. AIFS cost is = $32,025,000 AIFS unhedged cost = $37,000,000 AIFS improved its position from its base position by: $37,000,000 - $32,025,000 = $4,975,000 Q. After completing the expected scenario, now we can add more variables to the analysis: Using 75% options/25% forwards; 50% options/50% forwards, 25%options/75% forwards. A. See table on net page:

Cost of euro using options at 1.22 euros and 5% option premium

(1) mixed scenario's 75% option with 25% forwards total units of euro's option on 75% of 25,000,000 units of euro Option cost @ 105% or 1.22 * 105% 18,750,000euro's @ 1.28 forward hedge on remaing 25% of euro's Forward contract @ $1.22 * 6,250,000 euros Total cost using both 75% options @ 105% + 25% of forwards per unit price (2) mixed scenario's 25% option with 75% forwards total units of euro's option on 25% of 25,000,000 units of euro Option cost @ 1.22 * 105% 6,250,000 euro's @ 1.28 forward hedge on remaing 75% of euro's Forward contract @ $1.22 * 6,250,000 euros Total cost using both 25% options @ 105% + 75% of forwards @$1.22 per unit price (3) mixed scenario's 50% option with 50% forwards total units of euro's option on 50% of 25,000,000 units of euro Option cost $1.22 * 105% 12,500,000 euro's @ 1.28 forward hedge on remaing 50% of euro's Forward contract @ $1.22 * 12,500,000 euros Total cost using both 25% options @ 105% + 75% of forwards @$1.22 per unit price

Q. What is the best hedging strategy? A.

$

1.28 105%

$

25,000,000.00 18,750,000.00 1.28 24,018,750.00 6,250,000.00 7,625,000.00

$ $

31,643,750.00 1.27

$ $

$ $ $ $ $

25,000,000.00 6,250,000.00 1.28 8,006,250.00 18,750,000.00 22,875,000.00 30,881,250.00 1.24

$

25,000,000.00 12,500,000.00 1.28 16,012,500.00 12,500,000.00 15,250,000.00

$ $

31,262,500.00 1.25

$ $

75% 105% 25% 1.22

25% 105% 75% 1.22

50% 105% 50% 1.22

Q. Will the hedging picture look the same if final volumes are different? How will the analysis change if final volume is 30,000 or 10,000 instead of 25,000? If the volume changed by adding an additional 5,000 students, the analysis would be the same as before. We would only recalculate using the new 30,000 student number. If AIFS got hit by a “Surprise” like in the 2003 Iraq War, and had only 10,000 students the results would look like this: Cost unhedged at 1.22 euro's with a stable dollar assuming no change in euro stable dollar or current exchange rate `$1.22 * 25,000,000 UNITS EURO cost per student

If dollar remains stable What I actually pay for Euros @ $1.22 and $1.28 extra profit OR LOSS cost per student

If dollar becomes strong What I actually pay for Euros @ $1.01 and $1.28 extra profit cost per student

$1.22 $30,500,000.00 $3,050.00 $1.22 $30,500,000.00 $0.00 $3,050.00 $1.01 $25,250,000.00 $5,250,000.00 $2,525.00

The result is bad of course. If the base cost is $1,220 per student no matter how one hedges, it’s the volume problem, not the currency problem which is the real killer.