Prof.

Lin Guo FIN 417

HBS Case: Hedging Currency Risks at AIFS

Due date: April 12, 2012

Instructions: This case should be done individually. You should prepare a written analysis, and hand in two copies of your analysis on April 12 in class. Only hard copies of the case analysis are accepted. I will submit one of the copies to the Deans office for assessment purpose. Each student should also bring his/her own copy of the write-up to class, as well as the case itself, so that we can refer to the specifics in our discussion. The text analysis of your case should be about 3-5 pages (double-spaced). You should download the excel spreadsheet for the case at the Blackboard, complete the quantitative analysis using the spreadsheet, and attach the spreadsheet to your case write-up to support your arguments.

Your write-up should begin with an opening paragraph that defines the main problem in the case and your recommended solution. The remainder of your paper should support your conclusion and recommendations. This support should be based on your definition of the problem and inferences that you draw from the facts of the case. Structure is important for your argument to be lucid and transparent.

The grading will be based on the quality of your analysis and writing. Points will be deducted for grammar mistakes and typos.

Your case should address the following 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 outlined at the end of the case?

5. What hedging decision would you advocate?

Key Problem

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 euros. AIFS sets guaranteed prices for its exchanges and tours a year in advance, before its final sales figures are known. If the dollar depreciates against the Euro during this period, AIFSs cost would be higher when measuring in dollars, and negatively impact the firms profit. In order to hedge its foreign exchange exposure, AIFS can use an appropriate balance between forward contracts and currency options to achieve the goal.

The Case with No Hedging If the exchange rate remains constant at $1.22/euros then AIFS will not incur a foreign exchange loss or a gain. It would cost $1220 per participant at this exchange rate. If the dollar depreciates against euro, the actual dollar costs would be above $1220, and then there would be a negative impact. If actual dollar costs were lower than expected, the impact would be positive. Thus, with a sales volume of 25,000 participants and the exchange rate rises to $1.48/euros then AIFS will be subject to a loss of $4,391,892. If the exchange rate drops to $1.01/euros then AIFS will save $5,198,020.

The Case with Forward Hedging 100%

The Case with Option Hedging 100%

Sales Volume Variation

Recommendation Hedging Currency Risks at AIFS

1. The final sales volume and the final dollar exchange rate gives rise to the currency exposure risk. Prices are set 1 year ahead of time so any fluctuation in the exchange rate will potentially cause a loss or savings to AIFS when the currency is exchanged.

2. If the exchange rate remains constant at $1.22/euros then AIFS will not incur a loss or a gain. It would cost $1220 per participant at this exchange rate. If actual dollar costs were above this level, then there would be a negative impact. If actual dollar costs were lower than expected, the impact would be positive. Thus, with a sales volume of 25,000 participants and the exchange rate rises to $1.48/euros then AIFS will be subject to a loss of $4,391,892. If the exchange rate drops to $1.01/euros then AIFS will save $5,198,020.

3. With a 100% forward hedge under a final sales volume of 25,000 participants, AIFS is facing a dollar inflow of $25,000,000. Under this assumption, the optimal amount of expenses would be 1000 Euros per student. Risk arises when currency rates between the Euro and the dollar fluctuate. From the European perspective, there is 25 million Euros in underlying exposure. If 25 million Euros were bought forward at the 1.22 $/euro rate, then 30.5 million dollars will be sold. If the contract was signed in June 2004, then 1 year 30.5 million dollars can be spent for 25 million Euros, leaving a net position of 0 Euros and 30.5 million dollars (100% forward hedge). With this forward hedge, AIFS is completely mitigating the exchange rate risk between the dollar and the Euro, and are thus protected from losing money if the exchange rate approaches 1.48$/Euro. With a 100% option hedge,

4. The higher or lower sales volume would exaggerate whatever gains or losses AIFS will realize. We are able to utilize the AIFS shifting box to determine what the reactions to differing sales volume versus the exchange rate. If the volume is low and the exchange rate is out of the money, the loss will be lower than if the volume was the same as projected.

With a lower sales volume but in the money interest rate the gain would be realized, however again it would be smaller than the gain with the expected 25,000 participant value. For a higher sales volume and out of the money exchange rate the loss would be the highest possible, which can be hedged by using an option. If the sales volume is high and the rate is in the money, this would be the highest possible gain, however it would also require AIFS to buy more currency. This is both good and bad news, because the exchange rate could be out of the money by the time AIFS is able to buy more currency. However if the exchange rate was in the money this option would be the best possible situation, creating the highest revenues of all possibilities.

5. The option hedge strategy would be the policy we would advocate because AIFS purchases foreign currency based on the projected sales volumes. The option strategy provides the best protection from the fluctuation in both exchange rates and sales volumes. We believe that due to the industry in which AIFS operates, the company is more likely to experience higher fluctuations in sales volumes than in the exchange rates. The option strategy provides a more versatile option to hedge against this potential risk because AIFS will not be locked into a specific rate, as is the case with forward hedges.