Hedging Currency Risks at AIFS

Group Name: Jasen Turnbull Section: Sect 300 (2:30-3:45pm, Mon. & Wed.) Date: October 26th, 2010

1)

There are several factors that give rise to currency exposure at AIFS. One of these is the fact that most of their revenues are denominated in USD ($) but most of the expenses they incur are in foreign currencies (mainly Euros and British Pounds). One of the reasons AIFS hedges currency is to protect themselves from changing foreign exchange rates. This also protects them from one of their 3 major types of risk the bottom line risk, or the risk that foreign exchange rates could increase the firms cost base. The second type of risk AIFS encountered was sales volume risk. Since currency is traded based on projected sales, the actual sales amount at the end of the financial period could vary from the projections and a lower actual sales volume could be very damaging to AIFS financially. The third type of risk AIFS tries to hedge against is competitive pricing risk. This means regardless of how the exchange rates arep fluctuating, AIFS could not transfer rate changes into an increase in their price. Since AIFS does their banking with 6 different institutions, and maintains good, close relationships with each, AIFS is able to hedge with their lines of credit for each bank, rather than depositing funds in these banks to complete the transactions. This saves AIFS in transaction costs and the number of transactions since the banks know and trust them. The ultimate success of the hedging activities is determined by the final sales volume and the fair market value of the USD ($). If Archer-Lock and Tabacynzski did not hedge at all, it would mean they are fully exposed to currency risk. Fluctuations in the exchange rate can heavily impact revenues and expenses in either good or bad ways. For AIFS, if their revenues drastically drop and their expenses rise, this could mean big trouble for the firm as a going-concern. More specifically, in their case, if the USD($) depreciates, AIFS stands to lose money. Their revenues are less exposed due to the fact that most of the revenues are denominated in USD($). The same cannot be said about expenses, which are mostly denominated in foreign currencies and make AIFSs bottom line fluctuate more.

2)

Hedging Currency Risks at AIFS

3) If AIFS were to hedge against currency risk using 100% forward contracts, their position would be fully covered if they can accurately predict the amount and timing of the payments. If AIFS were to hedge using 100% options, they would be fully covered against currency risk, but would pay an option premium of $1,525,000. For the zero impact scenario, if the USD($) is strong compared to the Euro, this would have a positive impact on AIFS, because it reduces their costs incurred by $5.25 million. Ceteris paribus, except the dollar is weak compared to the Euro, this creates a negative impact for AIFS by increasing their costs by $6.5 million.

4)

If the company is running low on funds and the sales currently are low, the company is said to have an excess of currency. In this situation the option contract would be the best to use. AIFS should not enter into this contract but instead they should buy Euros at the current spot rate. If the company is in the money and sale are low a forward contract should be used for larger gains because of its nature to be less expensive then options contracts. On the other hand option contracts would be better if sales are high and the company is out of the money. Lastly, when sale are high and the company is said to be in the money, the loss that the company will incur will be in the difference between the volume of sales and the increase in exchange rates. 5) If AIFS is predicting exchange rates in their favor, they should choose to hedge with forward contracts because it guarantees the amount of cash flow of each respective currency that AIFS receives or distributes. AIFS also avoids paying a 5% premium that the option contracts carry. This is only favorable in the short-run though. The options contract would be better for AIFS in the long-run, because it has a type of insurance in the case of unfavorable changes in currency rates. In this case, AIFS has the option, not the obligation to exercise the contract.