Date: 17th August, 2012
American institute for foreign study (AIFS) is a multinational corporation based in USA and is well diversified across numerous countries. The firm is having a high transaction exposure which affects its bottom line to a great extent and it needs to minimize the exchange rate risks in order to sustain in the business.
AIFS has to hedge the currency before it knows about its exact requirement for the period. There are two main problems. What percentage of the expected costs it needs to cover. In what proportion should AIFS use options and futures?
These are two core issues in the case where the firm should look into to effectively protect itself from the risk offered by currency fluctuations. Other areas in which AIFS is struggling is competitive pricing risk. Once catalogs are printed and price is determined, it is bound to follow the pricing in subsequent years regardless of exchange rate.
Forecasting demand is also difficult because of uncertain conditions like terrorist attacks etc. put downward pressure on the overall business environment and the sales decrease drastically.
The primary objective of hedging activity at AIFS is to protect itself against unfavorable exchange rate fluctuations and simultaneously take advantage of favorable movements. The most important issue is to maximize the US dollar value of the Company’s assets, liabilities and future cash flows with respect to the exchange rate fluctuations. Major exposures faced by the firm are transaction exposure and translation exposure. Risks associated with both these exposures need to be minimized especially the transaction risks which is confronted directly.
Assumptions for Hedging
Following assumptions are taken while developing the financial model for hedging activity at AIFS. 1) The options and futures for the currencies are available as and when required. 2) Small transaction costs are ignored while calculating total cost. 3) There are three levels of dollar values assumed in the excel model. Strong Dollar (1.01 USD/EUR) Stable Dollar (1.22 USD/EUR) Weak Dollar (1.48 USD/EUR) This assumption as presented in the case has been inculcated into the excel model. 4) The demand has been divided into three levels. Low Demand (10,000 Students) Average Demand (25000 Students) Strong Demand (30000 Students)
Assumptions for Base scenario without Hedging
1. 10000 students registered to study in Europe from USA 5000 students registered to study in USA from Britain 3000 students from Europe registered to study in USA 2. Charge $ 1000 from a student from USA Charge 820 Euro from a student from Europe Charge 545 GBP from a student from Britain 3. Receive payment in USD and make payment in different currencies simultaneously at different point of time.
4. One third of the payment is made on each instalment 5. Number of enrollments is independent
The financial model for hedging at AIFS is constructed through MS Excel. The model provides a detailed comparison of all three currency rates with all levels of exposure and medium of hedging, viz. Options, Futures, No Hedging. The underlying conditions for the Model are: – Projected sales Volume – 25,000 participants Cost in Euro – 1000 Euros Initial exchange rate USD/EUR = 1.22 Cost in Dollars – $1220 Option Price – 5% of the total cost in denominated currency The following variables were used in the model:– 1) Four levels of total Cover (Hedging percentage) – 25% 50% 75% 100% 2) Three levels of Currency Exchange rate Strong Dollar (1.01 USD/EUR) Stable Dollar (1.22 USD/EUR) Weak Dollar (1.48 USD/EUR) 3) Three levels of Demand Low Demand (10,000 Students) Average Demand (25000 Students) Strong Demand (30000 Students) All the variables are used separately 3 times, once for each level of Demand. 4) Five levels of hedging by futures and options under a particular level of cover 0% Futures, 100% Options 25% Futures, 75% Options 50% Futures, 50% Options 75% Futures, 25% Options 100% Futures, 0% Options 5) A separate analysis is done when no hedging technique was used.
1) In case of Dollar strengthening, a 100% hedging with options results in cost optimization. This is because the company can buy more amount of foreign currencies with particular amount of dollars. 2) In case of a stable dollar, using Options will only add to the cost and ultimately result in a negative impact. If the Company thinks the currency market is not volatile then not hedging is the best option. But we suggest going for futures because firstly the Company will be protected from any negative currency movements just in case. Secondly, futures come free of cost and hence no extra cost is incurred in buying futures contract. 3) In case of dollar depreciating, hedging becomes necessary to protect itself against negative movements. Now if the firm is very sure of home currency depreciating, why should it pay premium for buying options? Futures come free of cost and protect effectively against currency exchange risks. 4) In case the home currency is too volatile and can go either way, applying any of the above strategies can be risky. In such a case the company can go for 100% cover with options. The above comment can be verified from the excel model. 5) The Company should go for 100% cover in all the situations as shown in the excel model.