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Hedging Currency Risk Essay

1859 words - 8 pages

The American Institute for Foreign Study (AIFS) is an organization, which helps enable American students to travel abroad. The main service AIFS provides entails organizing educational and cultural exchange problems across the globe. As the case explains, AIFS has split their business into two major divisions that that serve American student’s studying abroad; the Study Abroad College division and the High School Travel division. The college division, which is controlled by Christopher Archer-Lock, sends American students all over the world on semester-long exchange programs. The high school division, which was founded as the American Council for International Studies (ACIS), is controlled ...view middle of the document...

This results in a certain amount of volume risk, because they are unable to change the price, even in response to drastic changes in sales volume. This is particularly troublesome because their business, specifically the ACIS division, is highly susceptible to world events. If a world event is drastic enough, sales react almost immediately, which can result in as much as a 60% drop in volume. AIFS determines their pricing based on projected volume, so any drastic changes can have a significant effect on their profitability.
AIFS also faces a certain amount of competitive pricing risk, in large part due to their pricing policy, although all of their risk is closely related. Because they guarantee to keep their prices fixed, AIFS can’t adjust to adverse fluctuations in the exchange rate with changes to their pricing, which could give competition the ability to undercut their price. For example, if AIFS determines their catalog prices based on a projected volume of 25,000 and an exchange rate at 1.22 USD/EUR and then the dollar suddenly appreciates against the euro, they can’t lower their prices to match the change in their cost base, while a competitor without a pricing guarantee can take advantage of the situation and undercut AIFS’s price. However, the company’s pricing policy definitely has an advantage; over 70% of their sales are returning customers, according to Archer-Lock and Tabaczynski.
AIFS has a fairly simple solution in response to their exposure to currency risks; they use foreign exchange hedging to protect against unfavorable fluctuations in the exchange rates. Without hedging, the company would be exposed to 100% of the currency risk. According to Archer-Lock and Tabaczynski, the average cost per student is €1000; with a stable volume of 25,000 and the current exchange rate of 1.22USD/EUR, the total cost would be €25,0000,000 or $30,500,000. Without hedging to protect against bottom-line risk, the company’s costs could increase drastically if the exchange rate changes unfavorably. For example, if the euro appreciates against the dollar and the exchange rate is now 1.48USD/EUR, AIFS costs would increase 21.3% from $30,500,000 to $37,000,000 without hedging. This comparison is shown in the diagram below.

AIFS has many different options when determining how to hedge against their risk, including hedging with forwards, hedging with options, or using a combination of both forward and option contracts. In using the forecast final sales volume of 25,000, I was analyzed potential outcomes from a 100% hedge with forwards and a 100% hedge with options and compared the results relative to the zero-impact scenario mentioned by Archer-Lock and Tabaczynski.
AIFS can use forward contracts to purchase or sell a foreign currency at specified date in the future, which provides the company the ability to guarantee the exchange rate in the future. The benefit of a forward contract is obviously protecting against the risk of...

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