Case-currency hedging at american student exchanges

Reference no: EM131037103

Case: Currency Hedging at American Student Exchanges (ASE)

American Student Exchanges (ASE) is evaluating its foreign exchange hedging program. ASE currently uses a combination of options and forward contracts to protect its profits from damaging exchange rate changes.

ASE is a New York-based firm that arranges trips abroad for high school students and their teachers. The firm issues a catalog every fall containing prices for European trips that will be taken the following spring. A key feature of its business model is that ASE guarantees the prices in the catalog will not change, even if world events alter the firm's cost base. The firm feels that its strong customer loyalty is based on this price guarantee, and will not change this policy.

Example pricing and hedging timeline
Trips for the Fall 2016 catalog are priced; currency is hedged	Catalog is distributed; sales season begins; revenues in $	€ expenses are incurred
June 2016	September 2016	March 2017

ASE faces two types of risk due to their business model:

First, the dollar/euro exchange rate may fluctuate. ASE's CFO, Chris Taback, explains: "Suppose that we forecast expenses of €10 million and we set our catalog prices assuming one euro = one dollar. Now suppose a euro costs $1.20. Suddenly our expenses are $12 million instead of $10 million! This could put us out of business."

Second, the firm faces volume risk - that they may sell more or fewer trips than forecast. Thus they may buy enough currency to hedge 20,000 trips sold, but if they sell 30,000 trips they will need to buy euros on the spot market to make up the difference. On the other hand if they sell only 10,000 trips they may commit to buying too many euros and have to sell the excess.

Thus the ultimate success of ASE's hedging depends on the final sales volume as well as the $/€ exchange rate.

Taback uses the following graphic to explain:

Square 1

Sales volume than forecast Price of euro falls

Square 2

Sales volume lower than forecast Price of euro rises

Square 3

Sales Volume higher than forecast Price of euro falls

Square 4

Sales Volume higher than forecast Price of euro rises

"Square 1 means we bought the currency but don't need it because sales came in below projections. It's not a good place to be especially if we bought the euros via forward contracts, because we will lose money on them. Square 1 is what makes us consider using options and not just forwards. In Square 2, the exchange rate gain will hopefully help compensate for the lower sales volume. The gain will be larger with forwards than with options because the options cost around 5% of the strike price on average. In Square 3, sales volume was higher than expected, so we're short on euros. But, since the exchange rate fell we can just buy the extra currency on the spot market at favorable rates.

Square 4 combines good and bad news. Sales came in higher than expected, which is good, but it means that we

ASE's hedging policy addresses two key questions. First, what percentage of the firms' expected requirements should be covered? Second, what should be the proportion of forward contracts versus options?

Taback believes that ASE will sell around 25,000 trips this year. Right now (as the date of the case) one curo costs $1.22. Avenge costs per trip sold are 81000, so total dollar costs in this "base case" would be (1000)(1.22)(25,000) = $30.5 million.

But, all this can change. Taback wants to analyze the outcome of various hedging strategies, assuming a base case of 25,000 trips, but also considering sales levels of 10,000 and 30,000 trips, and also considering different exchange rates:

Stable dollar ($1.22 per euro)
Strong dollar ($1.02 per curo)
Weak dollar ($1.49 per euro)

Consider the following 4 hedging strategies:

1) Do nothing (no hedge)

2) Hedge expected 25,000 trips using forwards. Assume ASE can forward contract at the current price of $1.22.

3) Hedge expected 25,000 trips using (at-the-money) European call options with K = 1.22. Price the calls on till euro assuming that today is 6/1/2016, the options expire on 3/1/2017, the euro riskless rate is 0.25%, the US riskless rate is 0.50% and σ is 10%.

4) Mixed hedge: hedge 10,000 trips with forward contracts and another 20,000 trips with call options with K = 1.22. Value the calls as in #3.

Analyze each strategy under the 9 total 'Scenarios for trip volume/exchange rate. Consider the total cost of buying curos under each scenario, and compare it to the cost under the "base case" for that volume level. Thus, if a particular scenario when volume = 25,000 costs ASE $30 million, this scenario would have a positive impact of $0.5 million. If a particular scenario costs ASE $32 million, this scenario would have a negative impact of $1.5 million.

Once you have analyzed all scenarios, recommend a hedging policy for ASE.

Reference no: EM131037103

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