In consequence of the fluctuating exchange rate of USD against foreign currencies and the fact that AIFS fixes the price for their services before the costs can be estimated, the firm faces an inevitable currency exposure. In order to limit or eliminate this risk, AIFS has to hedge their currency exposure. At the moment the company hedges 100% of their exposure using forward contracts and currency options. Now Becky Tabaczynski, CFO of one of the main divisions, is creating a model, including different scenarios, with the goal of identifying which proportion of the exposure should be hedged at all and in which proportion forward contracts and currency options should be used for hedging.
Not hedging at all could have disastrous consequences for the whole company because in the case of a weak dollar the costs could rise drastically while the revenues remain fixed. Suppose the company has fixed the prices for the current season and now the costs in Europe are one million euros, while the exchange rate is at 1.20 USD/EUR. This means the firms costs are 1.2 million dollar. If the dollar weakens against the euro and the exchange rates rises to 1.32 USD/EUR, costs for AIFS would increase by 10%. Thus costs would increase by The higher the costs turn out, the higher this negative effect would be in nominal amount. The biggest stake of the costs are in euro and pound sterling, hence these two currencies are of major concern. In case of a strong dollar the company would profit the most without hedging but due to the downside trend of the dollar against euro and sterling simultaneously in short and medium term (Exhibit 6 & 7) there is reasonable evidence that AIFS should be prepared to cover their currency exposure.
If the company would use 100% forward contracts to hedge their costs, they would fix the costs, no matter what happens to the exchange rates of dollar to foreign currencies. An advantage of this strategy is that AIFS does not have to bear any costs entering the forward contracts, but on the other hand, it will neither make a profit in case the dollar strengthens nor will it suffer a loss in case the dollar weakens. A more flexible but meanwhile more expensive strategy to hedge is only using currency options. That means AIFS would have to pay the option premium in any case but this strategy allows to profit from unlimited favourable movements while limiting losses by the premium. So if the spot rate at expiry is higher than the strike price, AIFS can exercise their option and buy foreign currency for the lower strike price. And if the spot rate at expiry is less than the strike price, AIFS can forget about the option and buy for the lower spot rate. In any case the option premium has to be added to the costs. The possible outcomes in the two described strategies and a scenario with no hedge at all are summarized in the table below.
The table is based on a sales volume of 25,000 and average cost of â‚¬1,000 per participant. That means, with the current spot rate of 1.22 USD/EUR the costs would be $30,500,000 (â‚¬25,000,000 * 1.22 USD/EUR). The option premium in this case is 5% of the USD notional value that is hedged and three scenarios are examined:
The dollar strengthens (1.01 USD/EUR)
The dollar remains stable (1.22 USD/EUR)
The dollar weakens (1.48 USD/EUR)
In the first column the proportion of the hedged amount is given and in the second and third column of the table the proportions of forward contracts and currency options used to hedge are listed respectively. The fourth fifth and sixth column show the nominal effect on the costs in each scenario relative to the zero impact scenario (exchange rate remains stable at 1.22 USD/EUR) while it is assumed that in each hedging strategy the strike price is the current spot rate of 1.22 USD/EUR. Comparing the results of the table shows the advantages and disadvantages of each strategy. If 100% of the currency exposure is hedged only using options, the costs rise by $1,525,000 (which is exactly the option premium $30,500,000 * 5%) both in the zero impact scenario and in the scenario of 1.48 USD/EUR, since in both cases the option will be exercised.
In the case of a strong dollar (1.01 USD/EUR) the option will not be exercised since euros can be bought to the lower spot rate but the premium is lost. In total the costs still sink by 3,725,000 because the effect of the lower spot rate compensates the premium. Using only forward contracts to hedge results into no impact on the costs in any case since the exchange rate is fixed no matter what happens and there is no initial cost entering the contract. In case AIFS does not hedge at all, the costs either decrease by $5,250,000 if the exchange rate is 1.01 USD/EUR, or remain unchanged in the zero impact scenario or increase by $6,500,000 if the exchange rate is 1.48 USD/EUR. The impact on the cost if nothing is hedged arises merely from the difference in the spot rate and is much stronger than in the hedged case.
Since the company is highly affected by news of war, terrorism and political instability, events which are impossible to predict, I would suggest to alter their hedging policy and use mainly options for hedging. In case of such terrible news the forecasted volume of 25 thousand could drop up to 60%. That means in the worst case of a 60% drop, the companies costs decrease by 15 million euros but AIFS would be obliged to buy this amount if they are only hedged with forwards. Options instead would give the company more flexibility, which is a major issue since not only the exchange rates fluctuate but also the volume of participants. In my opinion AIFS should use proportions of 75% options and 25% forward contracts. In this way AIFS would fix the costs for a quarter of their exposure and still be flexible enough to react to different market circumstances and unforeseen events.
Moreover AIFS should keep covering 100% of their exposure because they have already experienced a loss of $700,000 in 1995 while they only hedged 80%. In addition the company should continue to deal with 6 different banks to reduce the counterpart risk. In the following table the impact on the costs in different scenarios are summarized using the same methodology as in the table above.
In the worst case scenario with 10,000 participants and in the scenario with 30,000 participants the currency exposure decreases to â‚¬10 million and increases to â‚¬30 million respectively but the impact on the costs using different proportions of forward contracts and options remains the same relatively speaking.
Instead of derivatives, an alternative possibility for AIFS to hedge their currency exposure would be to set up accounts abroad in foreign currency up to a certain amount. This would simplify the hedging approach and it would be reasonable the business model of AIFS forces them to keep foreign exchange every year.