Hedging Currency Risk

Introduction

American Institute for Foreign Study (AIFS) is an organization gain revenues in US dollars and incurs costs in other currency, mainly Euros since its branches are in Europe. The problem with different functional currency (Euro) and reporting currency (USD) would be that they might lose money through their operation with the change of exchange rate. A multinational company is required to by GAPP to convert foreign currency transactions into the functional currency. Translation of statements may result in translation difference, which needs cumulative translation adjustment. The recommended solution would be to offset this risk by forward contract or option contract depending different sales volume.

Causes Of Currency Exposure At AIFS

The main currency exposure at AIFS would be the volatility of spot exchange rate. The exchange rate changes over time due to macroeconomic factors such as trade balances, money supply and interest rate. The exchange rate would affect the revenue in reporting currency in both positive and negative way.

Another big challenge would the change of sales volume. This is a problem in that it only directly affects the revenue, but also affect the volume of hedging if the company try to avoid exchange rate risk.

Due to risks of fluctuating exchange rates, the company might consider hedge to protect themselves as I mentioned. When it estimated its sales volume (the number of student involved in this case), it should enter a forward or option contract for its sales. In doing so, it guarantees a price on the sales volume. As much as the hedging strategies can protect the company from risks, it comes with a price either of a premium in case of option or a loss of profit by positive change in exchange rate in case of forward contract.

Situation Of Not Hedging

In the basic situation (also called "zero-impact" situation), the future spot rate is the same as current spot rate (1.22Euro/USD). The company is actually paying 30,500 dollars in that situation.However, things would be much easier if both the sales volume and exchange rate stays the same.

Under the stable 25,000 volume, when the future exchange rate becomes stronger (USD/EURO=1.01), the company will have a windfall of 5,250 dollars; and when the exchange rate becomes weaker (USD/EURO=1.48), the company will have a windfall of negative 6,500 dollars.

Under the a higher volume of 30,000 sales, when the exchange rate stays the same, the company incurs 6,100 more than the stable amount, but experience no windfall; in the stronger dollar occasion where the future spot rate equals Euro1.01/USD, the company will have a winfall of 6,300 in total including the surprise volume of 1,050. Under weak dollar occasion where the future spot rate is Euro1.48/USD, the company will lose more money. It incurs a windfall