AIFS is an American based company that offers travel abroad and exchange study services to both college and high school students. While AIFS’s revenues are denominated in American Dollars (USD), most of their costs are in foreign currencies as Euros (EUR) and British Pounds (GBP). Consequently, foreign exchange hedging has a crucial importance for the company because it provides protection against different types of risk that derive from its activity.
In order to reduce risk, the company is using two hedging derivatives: forward contracts and put options to sell dollars. The aim of the paper is to determine an appropriate hedging policy which answers two main questions: how much to hedge, and in what proportions of forwards …show more content…
AIFS needs Euro to cover its costs, thus it can hedge through Put options (to sell dollars) or/and forward contracts to buy euros in the future.
We further examine the possibilities of fully hedging with forward contracts and fully hedging with options by taking into account only the risk of the fluctuation exchange rate and consider the volume sales of 25 000, as predicted. We consider that the company enters forward contracts and put options to (sell dollar) buy Euro at the forward price/strike price equal to the current USD/EUR rate of 1.22.
a) 100% of the total costs with 100% hedge with forward contracts
If the future spot price is equal to the forward price of 1,22USD/EUR and the company fully hedges with forward contracts, it will neither loss, nor win. The next scenario considers the case of a dollar price of 1,48USD/EUR. Since the forward price is lower than the future spot price, the company will gain the difference of (1,48-1,22)*25 000 000, thus a 6 500 000$ gain. (Exhibit 1) The last scenario accounts for a USD/EUR rate of 1,01. In this case, the company losses the difference between the forward price which is higher and the future spot price, that is 5