Question

2. As of July 2004, American Institute for Foreign Study (AIFS) hedge all its costs. Make a case (without any calculations) to CFO, Becky Tabaczynski, that

a) hedging all its costs may not be an optimal strategy for the corporation.

b) an option hedge makes a better choice than forward contracts for hedging. Would Becky Tabaczynski agree with your thought process?

Answer 1

(a): For AFIS hedging all its costs will not be an optimal strategy simply because when all costs are attempted to be hedged then the hedging does not remain effective. It should be noted that an effective hedging program does not attempt to eliminate all risk. The risks being faced by AFIS are bottom-line risk, volume risk and competitive pricing risk. AFIS cannot make its hedging strategy an effective one if it attempts to cover all these risks. Instead it should use its hedging strategy to transform all risks that are unacceptable to it into a form that makes these risks acceptable to the firm. This will help AFIS in achieving an optimal risk profile. Otherwise when all costs are attempted to be hedged then AFIS will not be able to balance the benefits of protection against the costs of hedging.

(b): Yes, Becky Tabaczynski will agree with my thought process. An option hedge is definitely a better choice than forward contracts for hedging simply because hedging with options is a more systematic method given the fluctuations in the exchange rates of USD, GBP and Euro. Secondly options are more secure than futures. Hedging with forwards may entail higher quantum of losses as it may require AFIS to exercise the forwards even in case of an adverse change in exchange rates, and the losses may be huge.