1. What gives rise to the currency exposure at AIFS?
American Institute for Foreign Study (AIFS) is a student exchange organization. It organizes exchange programs in education and culture throughout the world with two of its major divisions serving American students traveling abroad in the Study Abroad College division and High School Travel division. AIFS receives their revenues in American Dollars (USD) but incurs their costs and expenses in a foreign currency, mainly in the Euro (EUR) and the British Pound (GBP). AIFS’s currency is exposed to changes in the foreign exchange rate, therefore their gain or loss is determined by the appreciation or depreciation of the American dollar in the ...view middle of the document...
The Volume Risk
AIFS predicts its sales volume in advance based upon the data it has amassed over 40 years of doing cultural and educational exchanges. Using historical data is an effective way of estimating, but final sales will ultimately be different. It is impossible to accurately predict the exact increases or decreases in the amount of sales volume. Additional risks such as: news of war, terrorism, poor politics or any other uncertainties can affect the volume of sales. According to the case, sales at AIFS could drop up to 60% on such news. In the last 25 years four major events led to this drop: terrorism acts in 1986, the 1991 Gulf war, September 11 terrorist attacks and the War in Iraq in 2003.
When sales volume decreases AIFS is exposing their currency to a loss, if the exchange rate is unfavorable (out of the money) especially if they only have forward contracts. With options they will be able to exercise this instrument and wait for a favorable exchange rate in order not to lose money. If sales volume increases but the exchange rate is (out of the money) it will not affect the company when they buy currency to compensate for the extra volume however if the exchange rate is (in the money) AIFS will have to buy currency at a higher rate and hope that the increase in volume can offset the cost.
Competitive Pricing Risk
AIFS has a responsibility to provide fair prices to its loyal customers mainly composed of teachers and academic advisors who expect no sudden price increases (“surprises”) from AIFS. In order to maintain their 70% loyal customers AIFS guarantees their prices regardless of the currency rates and sales volumes. If rate changes depreciate the dollar AIFS must cover the cost. Without hedging their currency if the dollar depreciates AIFS will lose profits and customers to competitors if they must raise prices.
2. What would happen if Archer-Lock and Tabaczynski did not hedge at all?
If Archer-Locke and Tabaczynski did not hedge at all it would fully expose AIFS to currency risk. AIFS has the Study Abroad College division controlled by Archer-Lock who is also the treasurer as well as the Boston- Based High School Travel division whose finances are managed by Tabaczynski. The problem is that most of its revenues are received in American dollars (USD), but they incur their expenses in other currencies primarily Euro (EUR) and British Pounds (GBP). Without hedging AIFS might produce good results if: the American Dollar appreciates against the Euro or the British pound, sales volume is consistent and no other unforeseen costs are incurred. However exchange rates are extremely volatile, sales volume is unpredictable and the fact that AIFS guarantees their prices make hedging a necessity. For example, AIFS predicts sales to be 25,000 students and predicts the exchange...