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AIFS

is an international company that receives revenues in USD and incurs costs in EUR and GBP sterling.




Hedging Currency Risks at AIFS


Omar Chehimi, Mostafa Chebbo, Alexander Ardies, Saeed Taleghani
















The floating USD-EUR and USD-GBP exchange rates expose AIFS to currency fluctuations. As a provider
of educational and cultural exchange programs around the world catering for American students,
containing currency risk is part of AIFS regular business activity. The problem is that AIFS must hedge
before the sales cycle begins and prior to obtaining knowledge about foreign currency needs. AIFS has
two divisions one for college students and the other for high school students and teachers. Prices for
college student exchange programs (Summer and Spring) are fixed once per year and cannot be changed
between catalog release dates (interim price inelasticity). Similarly, prices for high-school programs are
fixed for each month in a calendar year once per year. The college division was more profitable than
the high-school division (ACIS) and was less susceptible to global risks arising from political instability.
ACIS had greater exposure to these risks and because of the low-profit high-volume nature of the
business; substantial drops in sales would expose AIFS to significantly more volume risk especially if
locked into surplus forward contracts (as evident from AIFS shifting box).
Pricing is determined competitively from the cost base and finalized taking into account the extent to
which AIFS hedge their foreign currency exposure. Because of competitive pricing, the possibility of
exchange rates moving against AIFS exposed them to significant risk.
The table below demonstrates what would happen if Archer-Lock and Tabaszynsky did not hedge at all:
Dollar remains stable:
$1.22*25000000 euro
cost per student


If the Dollar depreciates:
actual cost=1.48*25m
cost per student


If the Dollar appreciates:
actual cost=1.01*25m
cost per student

$ 1.22
$ 30,500,000.00
$ 1,220.00

$ 1.48
$ 37,000,000.00
$ 1,480.00

$ 1.01
$ 25,250,000.00
$ 1,010.00

It is clear therefore that without a hedge, they could loose up to $6.5M.


We can also consider what would happen if we hedge fully with forwards or options for different sales
forecasts. If we hedge with 100% forwards, the cost would be fixed at $1220 per student (assuming
actual sales equal forecasts). How much we gain or loose because of currency exposure if actual sales
turn out to be different from projected sales depends on the difference between realized sales and
forecasted sales. Here, AIFS would have to convert currency using current market spot rates.

With a 100% hedge with options, it would cost AIFS (25000*$1.22*1000)*(1.05) = $32.025M - if the
Dollar is stable (assuming premium equals 5% of hedged amount). If the cost of the Euro declines to
$1.01, then AIFS would choose to not exercise the option. Instead they would purchase at the prevailing
spot rate and only loose the premium they paid ($1.525M). Their profit in this event is:
Base cost (based on $1.22 per Euro) Cost of purchasing Euro at spot Premium paid on option =
$30.5M ($1.01*25000) - $1.525M = $3.725M.
If the Euro appreciates against the Dollar, the option is in the money so they pay $30.5M + $1.525M =
$32.025M. Without a hedge, this would have cost AIFS $1.48*25000=$37M. So they save $4.975M.
Again, we are assuming actual sales equal to projected sales if actual sales are higher, the hedge is not
sufficient to cover the depreciation of the Dollar. Buying at a higher rate than that used to price the
catalog leads to a loss unless this is offset by the profit made from the higher sales volume.
By considering the mixed scenarios of 75% options and 25% forwards, 25% option and 75% forwards,
and 50% options and 50% forwards, we can find the best strategy that has the lowest cost:

75% option and 25% forwards


25% option and 75% forwards
50% option and forwards

Cost of
Euro ($)
with hedge
1.265
1.235
1.245


The above prices were calculated as follows: First we determine the proportion of costs (in Euros) that
will be covered using options and then we multiply this number by $1.28 (cost factoring in premium).
The remainder is covered using forwards at $1.22. Next, we divide the total cost by 25000 (to compute
the cost per sale). From the above table, we would advocate the 25% options / 75% contracts hedging
decision. This gives us the lowest cost per sale. The table showing full results (for different coverage
levels) is shown in the appendix. To determine a more accurate range, we would consider the majority
cases where actual sales do not equal projected sales. We could do this by simulating a distribution of
volumes and a distribution of likely exchange rates. From these, we could determine the best hedging
strategy.
The hedging picture would look different if actual volume is less than that projected. For example if the
volume goes up and the exchange rates move against AIFS then they will have to purchase Euro at the
spot rate. But AIFS will still make a profit even if pricing is fixed. On the other hand, if volume declines,
then the company will suffer because they will have paid an unnecessary premium on options. If part of
their hedging strategy involves forward contracts, then they will have entered these unnecessarily also.
With only 10,000 students, AIFS would have overpaid (15/25 * $1.525M = $0.915M) in premium if they
hedged 100% in options and the exchange rate remained stable. This is the same as in the case where

the Dollar depreciates. If the Dollar appreciates, then they will not exercise the option and would have
lost the full premium paid ($1.525M).
If the hedge was 100% in forward contracts, AIFS loose nothing if the exchange rate remains stable. If
the Dollar depreciates, then they make a loss. AIFS make a profit if the Dollar appreciates so long as they
have the capital to cover the purchase of Euro from the counterparty.
APPENDIX

Volume
Stable rate
($)

Cost in
Euro per
Sale

25000

1000
0.05

1.22

Opt Prem

USD Exchange Rate (USD/EUR)

% Cover
100%
100%
100%
100%
100%

Contracts
0%
25%
50%
75%
100%

Options
100%
75%
50%
25%
0%

1.01
1.071
1.108
1.146
1.183
1.22

1.22
1.281
1.266
1.251
1.235
1.22

1.48
1.281
1.266
1.251
1.235
1.22

75%
75%
75%
75%
75%

0%
25%
50%
75%
100%

100%
75%
50%
25%
0%

1.056
1.084
1.112
1.140
1.168

1.266
1.254
1.243
1.231
1.22

1.331
1.319
1.308
1.296
1.285

50%
50%
50%
50%
50%

0%
25%
50%
75%
100%

100%
75%
50%
25%
0%

1.041
1.059
1.078
1.096
1.115

1.251
1.243
1.235
1.2278
1.22

1.381
1.373
1.366
1.358
1.35

25%
25%
25%
25%
25%

0%
25%
50%
75%
100%

100%
75%
50%
25%
0%

1.025
1.034
1.044
1.053
1.063

1.235
1.231
1.228
1.224
1.22

1.430
1.426
1.423
1.419
1.415

0%
0%
0%
0%
0%

0%
25%
50%
75%
100%

100%
75%
50%
25%
0%

1.01
1.01
1.01
1.01
1.01

1.22
1.22
1.22
1.22
1.22

1.48
1.48
1.48
1.48
1.48

Table showing effective USD/EUR rate paid (rate after hedge) for different coverage levels and hedging
combinations (assuming actual sales equal projected sales)

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