Question

Hedging Currency Risk at AIFS

The American Institute for Foreign Studies (AIFS) organizes study abroad programs and cultural

Exchanges for American students. The firm's revenues are mainly in U.S. dollars, but most of its

costs are in Eurodollars and British pounds. The company’s controllers review the hedging

Activities of AIFS. AIFS has a hedging policy, but the controllers want to review the percentage

Of exposure that is covered and the use of forward contracts and options. AIFS sets guaranteed

Prices for its exchanges and tours a year in advance, before its final sales figures are known. The

Controllers need to ensure that the company adequately hedges its foreign exchange exposure

And achieves an appropriate balance between forward contracts and currency options.

Assignment questions:

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 is outlined at the end of the case?

5.What hedging decision would you advocate?

Answer 1

1. AIFS is exposed to currency exposure as its revenues are mainly denominted in US Dollars, but its costs are denominated in EuroDollars and British Pound.

2. If they did not hedge at all, they remain exposed to the Foreign Exchange movement. As most of their expense is in EuroDollars and British Pound, against revenues in US Dollars, they will have to convert US Dollars to EuroDollar and British Pound to pay for their expenses. Hence, if EuroDollar and British Pound appreciates, then AIFS will have to pay high US Dollars leading to incremental costs.

3. A 100% hedge with forwards would lock in the costs or the rate of conversion of US Dollars into EuroDollar and British Pound and hence the cost will be known well in advance irrespective of the appreciation or depreciation of the foreign currency.

However, with 100% hedge with Option, AIFS will have the oppourtunity to earn higher returns in case the US Dollar appreciates (as the Company will not exercise the option). However, the costs are capped as in case the US Dollar depreciates, AIFS will exercise the options. Hence, options provides an opportunity to benefit if the exchange rates moves in the favor for AIFS.

The information to answer the second part is not provided.

4 and 5. The information for question 4 and 5 have not been provided.