Professional Documents
Culture Documents
is
an
international
company
that
receives
revenues
in
USD
and
incurs
costs
in
EUR
and
GBP
sterling.
The
floating
USD-EUR
and
USD-GBP
exchange
rates
expose
AIFS
to
currency
fluctuations.
As
a
provider
of
educational
and
cultural
exchange
programs
around
the
world
catering
for
American
students,
containing
currency
risk
is
part
of
AIFS
regular
business
activity.
The
problem
is
that
AIFS
must
hedge
before
the
sales
cycle
begins
and
prior
to
obtaining
knowledge
about
foreign
currency
needs.
AIFS
has
two
divisions
one
for
college
students
and
the
other
for
high
school
students
and
teachers.
Prices
for
college
student
exchange
programs
(Summer
and
Spring)
are
fixed
once
per
year
and
cannot
be
changed
between
catalog
release
dates
(interim
price
inelasticity).
Similarly,
prices
for
high-school
programs
are
fixed
for
each
month
in
a
calendar
year
once
per
year.
The
college
division
was
more
profitable
than
the
high-school
division
(ACIS)
and
was
less
susceptible
to
global
risks
arising
from
political
instability.
ACIS
had
greater
exposure
to
these
risks
and
because
of
the
low-profit
high-volume
nature
of
the
business;
substantial
drops
in
sales
would
expose
AIFS
to
significantly
more
volume
risk
especially
if
locked
into
surplus
forward
contracts
(as
evident
from
AIFS
shifting
box).
Pricing
is
determined
competitively
from
the
cost
base
and
finalized
taking
into
account
the
extent
to
which
AIFS
hedge
their
foreign
currency
exposure.
Because
of
competitive
pricing,
the
possibility
of
exchange
rates
moving
against
AIFS
exposed
them
to
significant
risk.
The
table
below
demonstrates
what
would
happen
if
Archer-Lock
and
Tabaszynsky
did
not
hedge
at
all:
Dollar
remains
stable:
$1.22*25000000
euro
cost
per
student
If
the
Dollar
depreciates:
actual
cost=1.48*25m
cost
per
student
If
the
Dollar
appreciates:
actual
cost=1.01*25m
cost
per
student
$
1.22
$
30,500,000.00
$
1,220.00
$
1.48
$
37,000,000.00
$
1,480.00
$
1.01
$
25,250,000.00
$
1,010.00
With
a
100%
hedge
with
options,
it
would
cost
AIFS
(25000*$1.22*1000)*(1.05)
=
$32.025M
-
if
the
Dollar
is
stable
(assuming
premium
equals
5%
of
hedged
amount).
If
the
cost
of
the
Euro
declines
to
$1.01,
then
AIFS
would
choose
to
not
exercise
the
option.
Instead
they
would
purchase
at
the
prevailing
spot
rate
and
only
loose
the
premium
they
paid
($1.525M).
Their
profit
in
this
event
is:
Base
cost
(based
on
$1.22
per
Euro)
Cost
of
purchasing
Euro
at
spot
Premium
paid
on
option
=
$30.5M
($1.01*25000)
-
$1.525M
=
$3.725M.
If
the
Euro
appreciates
against
the
Dollar,
the
option
is
in
the
money
so
they
pay
$30.5M
+
$1.525M
=
$32.025M.
Without
a
hedge,
this
would
have
cost
AIFS
$1.48*25000=$37M.
So
they
save
$4.975M.
Again,
we
are
assuming
actual
sales
equal
to
projected
sales
if
actual
sales
are
higher,
the
hedge
is
not
sufficient
to
cover
the
depreciation
of
the
Dollar.
Buying
at
a
higher
rate
than
that
used
to
price
the
catalog
leads
to
a
loss
unless
this
is
offset
by
the
profit
made
from
the
higher
sales
volume.
By
considering
the
mixed
scenarios
of
75%
options
and
25%
forwards,
25%
option
and
75%
forwards,
and
50%
options
and
50%
forwards,
we
can
find
the
best
strategy
that
has
the
lowest
cost:
Cost
of
Euro
($)
with
hedge
1.265
1.235
1.245
The
above
prices
were
calculated
as
follows:
First
we
determine
the
proportion
of
costs
(in
Euros)
that
will
be
covered
using
options
and
then
we
multiply
this
number
by
$1.28
(cost
factoring
in
premium).
The
remainder
is
covered
using
forwards
at
$1.22.
Next,
we
divide
the
total
cost
by
25000
(to
compute
the
cost
per
sale).
From
the
above
table,
we
would
advocate
the
25%
options
/
75%
contracts
hedging
decision.
This
gives
us
the
lowest
cost
per
sale.
The
table
showing
full
results
(for
different
coverage
levels)
is
shown
in
the
appendix.
To
determine
a
more
accurate
range,
we
would
consider
the
majority
cases
where
actual
sales
do
not
equal
projected
sales.
We
could
do
this
by
simulating
a
distribution
of
volumes
and
a
distribution
of
likely
exchange
rates.
From
these,
we
could
determine
the
best
hedging
strategy.
The
hedging
picture
would
look
different
if
actual
volume
is
less
than
that
projected.
For
example
if
the
volume
goes
up
and
the
exchange
rates
move
against
AIFS
then
they
will
have
to
purchase
Euro
at
the
spot
rate.
But
AIFS
will
still
make
a
profit
even
if
pricing
is
fixed.
On
the
other
hand,
if
volume
declines,
then
the
company
will
suffer
because
they
will
have
paid
an
unnecessary
premium
on
options.
If
part
of
their
hedging
strategy
involves
forward
contracts,
then
they
will
have
entered
these
unnecessarily
also.
With
only
10,000
students,
AIFS
would
have
overpaid
(15/25
*
$1.525M
=
$0.915M)
in
premium
if
they
hedged
100%
in
options
and
the
exchange
rate
remained
stable.
This
is
the
same
as
in
the
case
where
the
Dollar
depreciates.
If
the
Dollar
appreciates,
then
they
will
not
exercise
the
option
and
would
have
lost
the
full
premium
paid
($1.525M).
If
the
hedge
was
100%
in
forward
contracts,
AIFS
loose
nothing
if
the
exchange
rate
remains
stable.
If
the
Dollar
depreciates,
then
they
make
a
loss.
AIFS
make
a
profit
if
the
Dollar
appreciates
so
long
as
they
have
the
capital
to
cover
the
purchase
of
Euro
from
the
counterparty.
APPENDIX
Volume
Stable rate
($)
Cost in
Euro per
Sale
25000
1000
0.05
1.22
Opt Prem
% Cover
100%
100%
100%
100%
100%
Contracts
0%
25%
50%
75%
100%
Options
100%
75%
50%
25%
0%
1.01
1.071
1.108
1.146
1.183
1.22
1.22
1.281
1.266
1.251
1.235
1.22
1.48
1.281
1.266
1.251
1.235
1.22
75%
75%
75%
75%
75%
0%
25%
50%
75%
100%
100%
75%
50%
25%
0%
1.056
1.084
1.112
1.140
1.168
1.266
1.254
1.243
1.231
1.22
1.331
1.319
1.308
1.296
1.285
50%
50%
50%
50%
50%
0%
25%
50%
75%
100%
100%
75%
50%
25%
0%
1.041
1.059
1.078
1.096
1.115
1.251
1.243
1.235
1.2278
1.22
1.381
1.373
1.366
1.358
1.35
25%
25%
25%
25%
25%
0%
25%
50%
75%
100%
100%
75%
50%
25%
0%
1.025
1.034
1.044
1.053
1.063
1.235
1.231
1.228
1.224
1.22
1.430
1.426
1.423
1.419
1.415
0%
0%
0%
0%
0%
0%
25%
50%
75%
100%
100%
75%
50%
25%
0%
1.01
1.01
1.01
1.01
1.01
1.22
1.22
1.22
1.22
1.22
1.48
1.48
1.48
1.48
1.48
Table
showing
effective
USD/EUR
rate
paid
(rate
after
hedge)
for
different
coverage
levels
and
hedging
combinations
(assuming
actual
sales
equal
projected
sales)