Hedging Currency Risk at Aifs
Summary
AIFS is an American based company that offers travel abroad and exchange study services to both college and high school students. While AIFS’s revenues are denominated in American Dollars (USD), most of their costs are in foreign currencies as Euros (EUR) and British Pounds (GBP). Consequently, foreign exchange hedging has a crucial importance for the company because it provides protection against different types of risk that derive from its activity.
In order to reduce risk, the company is using two hedging derivatives: forward contracts and put options to sell dollars. The aim of the paper is to determine an appropriate hedging policy which answers two main questions: how much to hedge, and in what proportions of forwards versus options.
First, a description of the exposure of the company, particularly the three main risk factors: bottom-line risk, volume risk and competitive pricing risk is presented.
Then, we set the “impact zero” scenario: sales volume of 25 000, a cost of 1000€ for every costumer and an exchange rate of USD 1,22/EUR.
We consider three different exchange rate scenarios (weak, stable and strong dollar) and compare the costs for different alternatives of hedging.
We further introduce the second risk factor, different sales volume, and reach the conclusion that the alternative that bares the minimum cost for the company is to hedge 75% of the costs using options in proportion of 75% and 25% forward contacts.
1. Currency exposure at AIFS
The currency exposure at AIFS is given by the nature of their operations. AIFS’s revenues are mostly in American dollars, while the company’s costs are in other currencies, such as Euros and British Pounds.
The analysts of the company, Archer-Lock and Tabaczynski, projected a volume of sales for the next year of 25 000. The costs for each participant were calculated to be €1000, thus the total cost will reach €25 million. At a stable rate of the dollar against the euro of USD1,22/EUR , the
AIFS is an American based company that offers travel abroad and exchange study services to both college and high school students. While AIFS’s revenues are denominated in American Dollars (USD), most of their costs are in foreign currencies as Euros (EUR) and British Pounds (GBP). Consequently, foreign exchange hedging has a crucial importance for the company because it provides protection against different types of risk that derive from its activity.
In order to reduce risk, the company is using two hedging derivatives: forward contracts and put options to sell dollars. The aim of the paper is to determine an appropriate hedging policy which answers two main questions: how much to hedge, and in what proportions of forwards versus options.
First, a description of the exposure of the company, particularly the three main risk factors: bottom-line risk, volume risk and competitive pricing risk is presented.
Then, we set the “impact zero” scenario: sales volume of 25 000, a cost of 1000€ for every costumer and an exchange rate of USD 1,22/EUR.
We consider three different exchange rate scenarios (weak, stable and strong dollar) and compare the costs for different alternatives of hedging.
We further introduce the second risk factor, different sales volume, and reach the conclusion that the alternative that bares the minimum cost for the company is to hedge 75% of the costs using options in proportion of 75% and 25% forward contacts.
1. Currency exposure at AIFS
The currency exposure at AIFS is given by the nature of their operations. AIFS’s revenues are mostly in American dollars, while the company’s costs are in other currencies, such as Euros and British Pounds.
The analysts of the company, Archer-Lock and Tabaczynski, projected a volume of sales for the next year of 25 000. The costs for each participant were calculated to be €1000, thus the total cost will reach €25 million. At a stable rate of the dollar against the euro of USD1,22/EUR , the