AISF
AISF
world, which major divisions are the Study Abroad College division and the High School Travel division. AIFS receives revenues in USD, but incurred its costs in other currencies, thats why foreign exchange hedging is a very important issue for the AIFS. The 3 types of risk that AIFS is covering with hedging are: - Bottom-line risk, meaning an adverse change in exchange rates could increase the cost base. Tabaczynski explains that this movement can take you out of the business. - Volume risk. AIFS bought the foreign currency based on forecasted sales volumes, but in the moment that they would incur there would be differences from projected sales. - Competitive pricing risk, AIFS guaranteed that rate changes could not affect price. Two main instruments that AIFS is using to hedge the risk are forward contracts and currency options. The problem is that they have to do the hedging before sales. Archer-Lock (London-based controller for student exchange) and Becky Tabaczynski (CFO of groups high school travel division) are worrying about: a- what expected costs should they cover and, b- in what proportions should AIFS use forward contracts and options?
Recommendation: Hedging is considered to be an insurance especially for international companies. But as all the insurance contracts you have to pay money for it, but which kind of hedging is cheaper in different cases and how much should they hedge. AIFS case is a clear example to see that hedging tools, which seem easy to understand and to use in theory, are, in practice, not that easy to apply. The model that Tabaczynski created gives a better understanding of how hedging may be in different scenarios. Its not easy to decide 100 % between hedging with options or forwards. But considering the fluctuations that USD, Euro and GBP are having in the recent years it would be better to hedge some part with options and the other part with forwards. Option is a more expensive solution, but is more secure. If AIFS hedges with forwards it may lose more money because it may need to exercise the forwards even in case of an adverse change in exchange rates, and the losses may be huge. In case of options AIFS may decide not to exercise it in this case and the losses will be lower. AIFS should further refine the current spreadsheet model being followed by Tabaczynski - the model should give a picture of the situation considering extreme movements on both sides on all three parameters (sales volume, costs and actual exchange rate) for both divisions. Current model assumes 25000 units of sales. If sales projections are expected to be reasonably close, the model given in Exhibit 9 could be used. They used to cover only 80% of expected volume, which worked fine until in 1995 they have got much higher sales than they expected and lost $700,000 on the currency exchange. Therefore, it is better that they decided to cover 100% of expected costs through the hedging. Using only contracts or only options is not recommended as contracts will cover the company only in one direction (i. e. if they are long, then weaking will causes losses and vice versa). Only options will involve a lot of initial premium outlay which may make the hedging exercises itself very expensive. Ideal hedging strategy would be to have a mix of options and contracts. Option contracts
should be slightly lower to avoid excessive investments into the hedging. It's clear that because of upfront premium payment options may be costly for the company. But the exercise right and easiness of closing the position out shouldn't be neglected. When a long participant closes position he/she offsets the premium paid, yet not completely. However, it can reduce the costs. Forward contracts don't require any upfront payment, however, it gives obligation to the participants and it may be difficult to close the position out since these products are not standardized. The high school division forecasted sales for upcoming year is 25,000 participants. Historically, the high school division sales were affected by world events, such as 1986 terrorism acts, the 1991 Gulf War, the 2001 September 11 attacts and the 2003 Iraq war. In this case, sales could drop up to 60%, and based on the forecast of 25,000 participants, the worst case scenario is 40% of 25,000 and it is 10,000 participants . Therefore, if they will decide to have a conservative approach, then they should hedge high school division with 40% forwards and 60% options. In this case, the upfront premium for options on 15 million euros will cost $915,000. This is very costly option, but, at the same time, if they wont need any portion of the options, they can can just go away losing only the upfront premium of 5%. On the other hand, if the sales will go up to 30,000 participants, then they might lose on the exchange rate, like they did in 1995, when they lost $700,000 because they covered only 80% of sales. Considering all three scenarios, we would suggest them to cover 60%-70% of the sales with forwards, an 30%-40% with options. The chances that the next years sales will be closer to forecast are higher, than the worst or best case scenarios. The college division is forecasted to have 5,000 participants. Since, college sales are not affected by world events that were mentioned before, they can probably hedge 95%-100% of the forecasted sales with the forwards, and if they choose 95% hedging with forwards, then the rest 5% should be covered with options. Also, we are looking at the 2005 year sales, and if this would be 2011, the recommendation would have been different. Analysing current situation on the market, where exchange rates are less volatile than before, many companies stopped hedging to avoid excess hedging costs, and just use the spot rate to exchange currency based on the actual transactions.