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 Dean’s 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?

dollars.22/euros then AIFS will not incur a foreign exchange loss or a gain. The firm's revenues are mainly in U.000 participants and the exchange rate rises to $1. before its final sales figures are known. Thus.020. If the dollar depreciates against euro. What happens if sales volumes are lower or higher than expected as outlined at the end of the case? 5. It would cost $1220 per participant at this exchange rate.01/euros then AIFS will save $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.S. AIFS can use an appropriate balance between forward contracts and currency options to achieve the goal. but most of its costs are in euros. In order to hedge its foreign exchange exposure.198. The Case with Forward Hedging 100% . with a sales volume of 25. If actual dollar costs were lower than expected.391. AIFS’s cost would be higher when measuring in dollars. and then there would be a negative impact. AIFS sets guaranteed prices for its exchanges and tours a year in advance. the actual dollar costs would be above $1220. the impact would be positive. If the exchange rate drops to $1. If the dollar depreciates against the Euro during this period. What would happen with a 100% hedge with forwards? A 100% hedge with options? Use the forecast final sales volume of 25.892. The Case with No Hedging If the exchange rate remains constant at $1.3. and negatively impact the firm’s profit.48/euros then AIFS will be subject to a loss of $4. 4.000 and analyze the possible outcomes relative to the "zero impact" scenario described in the case.

the loss will be lower than if the volume was the same as projected.000 participants and the exchange rate rises to $1. then 30. and are thus protected from losing money if the exchange rate approaches 1. With this forward hedge. 2. with a sales volume of 25. Thus.5 million dollars (100% forward hedge).391.020. then there would be a negative impact. there is 25 million Euros in underlying exposure. AIFS is completely mitigating the exchange rate risk between the dollar and the Euro. AIFS is facing a dollar inflow of $25. From the European perspective.000. leaving a net position of 0 Euros and 30.48$/Euro. With a 100% option hedge.000 participants. Risk arises when currency rates between the Euro and the dollar fluctuate. Under this assumption. It would cost $1220 per participant at this exchange rate. 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. .198. We are able to utilize the AIFS shifting box to determine what the reactions to differing sales volume versus the exchange rate.5 million dollars will be sold. If the volume is low and the exchange rate is out of the money.000. 4.01/euros then AIFS will save $5. If the exchange rate remains constant at $1. the optimal amount of expenses would be 1000 Euros per student. The final sales volume and the final dollar exchange rate gives rise to the currency exposure risk. If the exchange rate drops to $1. 3.22 $/euro rate. If 25 million Euros were bought forward at the 1. If actual dollar costs were lower than expected.892.48/euros then AIFS will be subject to a loss of $4. then 1 year 30. With a 100% forward hedge under a final sales volume of 25. If the contract was signed in June 2004.22/euros then AIFS will not incur a loss or a gain.5 million dollars can be spent for 25 million Euros. The higher or lower sales volume would exaggerate whatever gains or losses AIFS will realize. the impact would be positive.The Case with Option Hedging 100% Sales Volume Variation Recommendation Hedging Currency Risks at AIFS 1. If actual dollar costs were above this level.

However if the exchange rate was in the money this option would be the best possible situation. however again it would be smaller than the gain with the expected 25. The option hedge strategy would be the policy we would advocate because AIFS purchases foreign currency based on the projected sales volumes. This is both good and bad news. which can be hedged by using an option. For a higher sales volume and out of the money exchange rate the loss would be the highest possible. creating the highest revenues of all possibilities. because the exchange rate could be out of the money by the time AIFS is able to buy more currency. 5. this would be the highest possible gain. The option strategy provides a more versatile option to hedge against this potential risk because AIFS will not be locked into a specific rate.000 participant value. If the sales volume is high and the rate is in the money. 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.With a lower sales volume but in the money interest rate the gain would be realized. however it would also require AIFS to buy more currency. The option strategy provides the best protection from the fluctuation in both exchange rates and sales volumes. as is the case with forward hedges. .

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