Currency Exposure to Hedging Currency Risks

Hedging Currency Risks at AIFS, we shall now address the many stipulations regarding issues such as currency exposure and hedging decisions of the AIFS Company. Looking at the theory and practices of Archer-Lock within the company, with the information given we shall now analyze and interpret the report of AIFS. Using the financial Instruments of the foreign exchange market, the effect these instruments have on hedging will further be discussed, as well as the result of these instruments on the hedging decision.

It is important to note that Becky Tabaczynski, CFO for the group’s high school travel division ACIS, portrayed the idea a good hedging result is gained due to good relationships across the board. Whilst in some companies, hedging is considered a financial decision, independent of the business needs – here; we’re trying to match the business needs. Now with the information provided in the case study, combined with knowledge of hedging options, the topic of currency exposure will be discussed.

Q1. What gives rise to the currency exposure at AIFS?

Currency exposure is the extent to which the future cash flows of an enterprise, arising from domestic and foreign currency denominated transactions involving assets and liabilities, and generating revenues and expenses are susceptible to variations in foreign currency exchange rates (International Federation of Accountants, 2010).

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Currency exposure at AIFS can be caused by 3 risks: the bottom-line risk, volume risk and competitive pricing risk. These 3 risks happen at AIFS because of the AIFS’s hedging policies, so before analysing these 3 risks it is necessary to analyse AIFS’s hedging policies.

AIFS’s Hedging Policies

AIFS starts to hedge foreign currencies between 6 months and 2 years before the main pricing date, and uses forward contracts and currency options to hedge currency; the main hedging technique is forward contracts. Then AIFS uses these currencies to pay its customers’ expense abroad. AIFS charges USD by “catalogue-based” price from its customers, so no matter how the exchange rates change in the spot market, AIFS never changes its price in that period.

AIFS uses forward contract to hedge before it has completed its sales cycle. So AIFS has to predict its business then hedge based on its prediction, but the situation that the number AIFS pays equals to the number AIFS buys is very hard to carry out. When the currencies that AIFS has bought are smaller than it has to pay, AIFS has to buy some more currencies by using currency options. When the currencies it has bought are greater than it has to pay, currency exposure happens.

The Bottom- Line Risk

Exchange rate is always fluctuant. EURO is one of the main currencies that AIFS needs to hedge. Looking at the graph, the exchange rate between USD and EURO in January was highest in 2010, which was 1.427$/€, and the exchange rate in June was the lowest, which was only 1.221$/€, the difference between highest and lowest is 0.206€/$, so when purchasing large amounts of EURO by using USD, the large difference of price will appear. The main hedging technique of AIFS is forward contracts, so if the exchange rate at the contract date is higher than the exchange rate at the settlement date, AIFS is at a disadvantage (maybe AIFS can choose currency options at this time, but it needs to pay premium, so the cost may be not reduced so much). When this situation happens, AIFS’s cost will be higher and it will lose profit.

2010- American Dollars to 1 EUR

Average Rates

January

1.42721 USD (20 days average)

February

1.36857 USD (20 days average)

March

1.35685 USD (23 days average)

April

1.34095 USD (21 days average)

May

1.25653 USD (21 days average)

June

1.22085 USD (22 days average)

July

1.277 USD (22 days average)

August

1.29029 USD (21 days average)

September

1.3067 USD (22 days average)

October

1.38978 USD (21 days average)

November

1.38806 USD (12 days average)

From X- rate.com, 2010

The Volume Risk

When AIFS uses forward contract to hedge currencies, it doesn’t know the number of customers it will get in this period. AIFS has been doing culture and educational exchanges for more than 40 years and got a very good praise and has a large number of customers, every year many young people go abroad via AFIS. Because it’s so popular, it’s hard to say how many customers will be increased next time. Also, war, terrorism and policies and other uncertainties will affect people’s mind, these factors will make more people prefer to stay at home rather than go abroad, and in that case the number of customers will be decreased. So it’s hard to predict the number of customers, it’s hard to say whether the number of customers will increase or decrease. In negative situations where there will be a lack of customers, the foreign currencies that have been bought will not be used; this is when currency exposure is evident.

The Competitive Pricing Risk

When AIFS is purchasing and using currencies, its competitors are doing it as well. These companies may contract with banks in lower exchange rates, which makes their charges lower than AIFS and therefore makes AIFS less competitive. Customers may buy currencies from other companies, and so AIFS’s currencies can’t be sold up and currency exposure happens.

The changes of transportation fees (like train, boat, plane ticket), living fees, hotel fees can also give rise to the currency exposure. When these fees reduced, AIFS will pay less and may not use all of the currencies it has bought.

According to AIFS’s hedging policies, it has to predict the exchange rate fluctuant, the number of customers, which may be different with the final exchange rate and the volume when selling currencies, so the currency exposure happens. The actions of AIFS’s competitors may make AIFS less competitive resulting in minimum sales of the currencies bought, further resulting in currency exposure. So the bottom-line risk, the volume risk and the competitive pricing risk will give rise to the currency exposure at AIFS. Also, the changes of fees may cause currency exposure.

Q2. What would happen if Archer-Lock and Tabaczynski did not hedge at all?

According to the case, The American Institute for Foreign Students (AIFS) organizes students who study abroad and the cultural exchange programs. It has two major divisions which are Archer-Lock managed The Study Abroad College and the High School Travel division, whose finances Tabaczynski managed. The problem faced by AIFS is the revenues of the company are mainly in US dollars, but most of their costs are in British pounds and Euros. AIFS sets guaranteed prices for its exchanges before its final sales figures are known. Therefore, for AIFS, the foreign exchange hedging is the key important area. The managers use currency hedging to protect their bottom line and cope with changes in exchange rates. But if Archer-Lock and Tabaczynski did not hedge at all, it would mean full exposure to the currency risk, the company could lose a lot of money if USD depreciated.

Maybe the company can produce good results and have a really good profit when the USD appreciated if they did not hedge at all, as there are no other losses to erase their total revenue. However, they cannot know what the future sales volume and future exchange rate are, and so they may need to face losing a tremendous amount of money if USD depreciated. The cost base of the company would increase, and the revenues in USD will remain the same, this means their profitability would be erased. Also, AIFS needs to preserve their price guarantee policy. If they did not hedge at all, the company may incur losses by following this policy. Moreover, there may be a difference between final sales volumes and projected sales volume, and this exposes the company to having either more or less of the foreign currency depending on the final sales volume. For instance, as we know from the case, every year AIFS expected 25,000 students in their project. If the currency exchange rate decreased to USD 1.01/EUR, the company could save USD 5.25 million, however, if the exchange rate increased to USD 1.48/EUR, the company lose USD 6.5 million.

Q3. 100% hedge with option and 100% hedge with forward

The data shows above, When 100% hedge with option, currency rate 1.01, and the outcome is higher than total cost, the company can gain the profit. Rate becomes to 1.22 and 1.48, the outcome is lower than total cost, and the company has risk and a loss of money. When 100% hedge with forward, the fixed rate is locked in 1.22, the outcome is 0. That is means no risk and no profit.

Q4. Using the forecast final sales volume of 25,000, the following are the possible outcomes relative to the ‘zero impact’ scenario described in the case.

Zero impact happened with rate (1.22) when they use forward contract were the same as project costs. When dollar becomes weak (1.48) it would cause a negative impact by a loss of money. When dollar becomes strong (1.01) it would cause a positive impact through gain of profit.

When the USD is strong (1.01), the more options there are to hedge, the lower the cost. When USD is weak (1.48) the more options there are to hedge, the more the cost.

Q5) what hedging decision would you advocate?

Should we not hedge at all?

As AIFS guaranteed its prices would not change before the next catalogue, if the USD goes weak, AIFS need to more USD to pay for its overseas cost¸ however the price cannot be changed, which means AIFS will lose money. To eliminate this risk, AIFS better hedge.

What do you advocate?

(Advantages and Disadvantages)

The forward contract is a simple arrangement widely used by the companies to manage the exchange rate risk. It can guarantee the amount of currency AIFS would receive in the expiry date of the contract, so it can get larger profits with forward contracts if AIFS count on a favourable exchange rate. The company can also avoid the 5% option premium, but it is not easy to get the counter party who would agree to fix the time period and the future exchange rate which would result in illiquidity. Thus being bilateral private contracts, the forwards have to be executed.

The option contract can eliminate the downside risk and being more flexible, it can be seen as a combination of covered interest arbitrage depending on the difference in currency options and interest rates; it gives the company the right to sell or purchase a currency at an agreed exchange rate, but not the obligation. With the option contracts AIFS can hold the currency until the favourable exchange rate arises, so it would be more secure for the company. However, the premium cost is the disadvantage of option, and it has to be paid up front.

Both forward contract and option contact work if the company is tight on cash and cannot spend 5% option premium – in this case the forwards contract is a better choice. However, if AIFS has sufficient funds and foresees changes in exchange rates, then it should use option. AIFS does not have to exercise the contract when currency moves to unfavourable exchange rates.

What happens if sales volumes are lower (10000) or higher (30000) than expected (25000)?

According to appendix 3 and 4:

The sales volume increase to 30000, exchange rate is 1.01. AIFS Company can gain the profit. Exchange rate is 1.22 and 1.48, AIFS Company exist risk loss the money; but when use 100% forward to hedge Company can avoids risk and there is no profit.

The sales volume is decrease to 10000, the total cost is 1000* 10000= €10000000

There are 3 possible situations that will happen at this time.

= 0.4 = 40%

According to the calculation above, when AIFS’s currency hedge is covered less than 40% of its prediction (it predicts 25000 sales volumes), AIFS needs to buy some more currency to reach €10000000 by using spot trading rate; when AIFS’s currency hedge is covered at 40%, the currency it buys is equal to €10000000; when the currency hedge covered over 40%, AIFS can’t use all of the EUR it has bought, so AIFS has to sell the extra EUR or save them and use them in the next period.

1.48

1.01

10000

30000

Source: AIFS case

There will be 4 outcomes with the ‘in the money’ and ‘out of money’ positions and high and low sales volume (30000 or 10000).

Square 1 shows low sales volume (10000) with strong USD that when the company is out of money (1.01USD/EUR). AIFS has an excess of currency. In this case, if it locked into surplus forward contracts then it would lose money. So the option contract is more favourable. AIFS does not execute the contract, it just lets it expire.

In square 2 shows low sales volume (10000) with weak USD, The requirement of the currency is below the projection (25000), and the exchange rate is high (1.48USD/EUR). If AIFS uses forward contract the gain is larger compared to when it uses options contract because the options contract costs 5% of the nominal USD strike price.

In square 3 the exchange rate moved out of money (1.01USD/EUR) and the sales go higher (30000) than expected. So AIFS doesn’t have to buy euro at higher rate, therefore, the Options contract is better, as the extra volume they need (5000), can be bought at the spot rate. The increase of the Spot and Fixed rates and the difference of the volume of sales are the reason for company loss.

The tricky square 4 shows when the exchange rate moved in the money (1.48 USD/EUR) and AIFS’s sales volume came in higher (30000) than projections, which means the company need more currency (5000), however, the exchange rate is high. In this case, Forward contracts should be used and the extra volume at the spot rates should be bought. The increase of sales may offset the downside.

For companies that work with more than one currency, several hedging techniques are available to guard against foreign exchange fluctuations. After studying and addressing the case study of AIFS, it can be concluded that the changes in fees can be the cause to currency exposure. The fact that the company’s revenues are in USD, and costs in GBP and Euro’s may result in a rise to currency exposure. After analyzing the affects of financial instruments such as forward and option contracts will have on the company, it has been decided that the company would be at a better advantage with Forward contract in order to prevent risks. AIFS charges USD by “catalogue-based” prices from its customer, and as the company guaranteed the prices will not change, if the rate of the USD decreases then the company will be at a loss as they will have to cover other expenses with the currency they have bought, and in order to prevent this risk, the company would be in a better position if they hedged.

REFERENCES:

International Federation of Accountants, 2010,

http://www.mia.org.my/handbook/guide/imap/imap_3.htm#Business%20Implications

[Accessed on 4/11/2010]

X-rate.com, 2010, http://www.x-rates.com/d/USD/EUR/hist2010.html [Accessed on 16/11/2010]