Question

Assume you are the CFO of AIFS. Your analyst reports the following information (Use the following information for the remainder of the assignment):

• Current exchange rate is $1.16/€.

• Forward rate is $1.185/€.

• Expected final sales volume is 30,000. Worst case scenario is volume of 10,000. Best case scenario is volume of 36,000

. • Cost per student is €2500.

• Option premium is 2% of USD strike price.

• Option strike price is $1.165/€.

As the CFO, you decided to hedge using option contracts. Assuming expected final sales volume is 30,000, what are your total benefit/cost and the percentage benefit/cost from hedging (compared to no hedging)

No hedging at $1.16/€= $87,000,000

No hedging at $1.25/€= $93,750,000

No hedging at $1.08/€= $81,000,000

**Show full working solutions**

a) if the exchange rate remains at $1.16/€?

b) if the exchange rate will be $1.25/€?

c) if the exchange rate will be $1.08/€?

Answer 1

Solution:

Expected Sales Volume	30,000
Cost per Student	2500	Euro
Expected Sales	75000000
	75	Million Euro

Option Stike Price	1.165	$/Euro
Option premium	2%
Option premium in ($)	0.0233	$

Strategy for Hedging: As AIFS is going to receive cash flows in Euros, to protect dollar amount of sale, it will buy the put option of strike price 1.165 $/Euro

Number of Option Contracts for hedging entire exposure	75	Million
Premium paid on option contract	1.7475	Mn $	(Number of contracts x Option premium in $)

a) if the exchange rate remains at $1.16/€?
No Hedging
Total Sales	87	Mn $	(75 Mn Euro x 1.16)
Hedging
Total Sales	87	Mn $
Less: Option Premium Paid	1.7475	Mn $
Add: Gain from Option	0.375	Mn $	(Max(1.165-1.16,0)*Option Contracts)
Total Hedged Revenue	85.6275	Mn $
Ans: No Hedging cash flows are higher than with hedging cash flows
b) if the exchange rate will be $1.25/€?
No Hedging
Total Sales	93.75	Mn $	(75 Mn Euro x 1.25)
Hedging
Total Sales	93.75	Mn $
Less: Option Premium Paid	1.7475	Mn $
Add: Gain from Option	0	Mn $	(Max(1.165-1.25,0)*Option Contracts)
Total Hedged Revenue	92.0025	Mn $
Ans: No Hedging cash flows are higher than with hedging cash flows
c) if the exchange rate will be $1.08/€?
No Hedging
Total Sales	81	Mn $	(75 Mn Euro x 1.08\)
Hedging
Total Sales	81	Mn $
Less: Option Premium Paid	1.7475	Mn $
Add: Gain from Option	6.375	Mn $	(Max(1.165-1.25,0)*Option Contracts)
Total Hedged Revenue	85.6275	Mn $
Ans: Hedging cash flows are Higher than Non-Hedging Cash Flows