1. Currency Futures and Options with AIFS

2. What is AIFS?
Founded in 1964, sends more than 50,000 students each year on academic and cultural exchange programs worldwide.
Two main divisions: College and High School travel.
HS division had lower margins and more sensitive to world events (1-4 week trips).
College division organized academic visits for a semester, an academic year, or a summer.

3. How does AIFS operate?
Publish catalogs in advance of the upcoming academic year with prices that were guaranteed.
Ex: For college, publish in July 2004 for Summer 2005 and Fall 2005/Spring 2006 trips.
Ex: For HS, publish early for next calendar year.
Trips mainly to Europe.
Prices quoted in dollars. Expenses in foreign currency (mainly euros)

4. What risks does AIFS currently face?
Exchange Rate Risk (they call it bottom line risk)
Demand Risk (they call it volume risk)
They also throw in “competitive risk,” which goes along with the exchange rate risk… their customers are sensitive to big changes in price. Prices are guaranteed once published. So, they can’t just pass along the exchange rate risk to their customers.
Repeat business is key to their success (the teachers, not the students, are their focus)

5. Do they have risk management techniques already in place?
They currently use Forward contracts and options to hedge their exchange rate risk. Spread risk around with 6 different banks.
They focus on two questions:
What percent of expected requirements should they hedge (they do 100% now… did less in the past and got burned).
What should be the percentage breakdown of options vs. forward contracts for risk management purposes?

6. Figure 2 in Case Actual Sales Volume Compared to Projected
Higher
Lower
Exchange Rate
Strong Dollar
Weak Dollar

7. The Analysis Risk Management Scenarios: Exchange Rate Scenarios:
Do nothing
100% Forward Hedging
100% Options Insurance
Exchange Rate Scenarios:
Stable Exchange Rate -- $1.22/€  ”Baseline”
Strengthening Dollar Exchange Rate -- $1.01/€
Weakening Dollar Exchange Rate -- $1.48/€
Volume (Demand) Scenarios:
25,000 customers (base case)… 10,000 & 30,000

8. Zero Impact Case (“Baseline”)
25,000 customers
€1000 cost each
€ 25 million total cost
@ $1.22/€… $30.5 million total cost
These are the costs that they expect. They will price their trips accordingly.

9. Positive or Negative Windfall Graph
Windfall/Surprise
$/€
1.01
1.22
1.48

10. Scenario #1: No Hedge Total Expected Cost of Euros is $30.5 million.
If Exchange Rate…
… is $1.22/ €, costs come in as expected. No pos or neg windfall.
… is $1.01/ €, costs are €25 million x 1.01 = $25.25 million. This is a positive windfall ($ $25.25 = $5.25 million!)
… is $1.48 / €, costs are €25 million x 1.48 = $37 million. This is a negative windfall ($ $37 = -$6.5 million!)

11. Positive or Negative Windfall Graph
Windfall/Surprise
5.25
$/€
1.01
1.22
1.48
-6.50

12. Scenario #2: 100% Forward Contracts
Bank
$30.5m
€25 m
AIFS
Supplier
€25 m

13. Scenario #2: 100% Forward Contracts
Total Expected Cost of Euros is $30.5 million.
If Exchange Rate…
… is $1.22/ €, costs come in as expected. No pos or neg windfall.
… is $1.01/ €, costs come in as expected. No pos or neg windfall.
… is $1.48 / €, costs come in as expected. No pos or neg windfall.

14. Positive or Negative Windfall Graph
Windfall/Surprise
5.25
$/€
1.01
1.22
1.48
-6.50

15. Scenario #3: 100% Options
Buy a call option with right to purchase Euros at $1.22/ €.
Options have a premium: 5% of USD Value
$30.5 million x 5% = $1.525 million premium
If Exchange Rate…
… is $1.22/ €, costs come in as expected. No pos or neg windfall, but net costs = -$1.525 million
… is $1.01/ €, costs are €25 million x 1.01 = $25.25 million. This is a positive windfall ($ $25.25 = $5.25 million!). But it is decreased by the premium: $ $1.525 = $3.725
… is $1.48 / €, costs would be €25 million x 1.48 = $37 million, but option exercised and windfall = 0, but net costs = -$1.525 million.

16. Positive or Negative Windfall Graph
Windfall/Surprise
5.25
3.73
$/€
-1.53
1.01
1.22
1.48
-6.50

17. Recap: Outcomes for Risk Mgmt Strategies with 25,000 students
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Expecting to pay:
€25,000,000 or
$30,500,000
No Hedge
Costs:
$25,250,000
$37,000,000
Windfall:
$5,250,000 $0
($6,500,000)
100% Fwds
100% Options
$26,775,000
$32,025,000
$3,725,000
($1,525,000)

18. Which to choose?
Do Nothing
Futures
Options

19. Volume Risk!
Suppose that AIFS’s volume comes in higher or lower than 25,000 (specifically, assume 30,000 or 10,000).
Reanalyze the 3 strategies we just calculated windfalls for, but assume that after the hedging was put into place based on an expected 25,000 students (if there was hedging at all), the actual number of students was different.
Calculate the pos/neg windfalls under the 30,000 and 10,000 student scenarios. Graph the windfalls.

20. Planned for 25,000 students, but 30,000 want to go abroad (Do Nothing)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy $0
Expected cost to buy €30,000,000
$36,600,000
Risk Mgmt Action Taken?
N/A
Actual cost to buy €30,000,000
($30,300,000)
($36,600,000)
($44,400,000)
Total Windfall
$6,300,000
($7,800,000)

21. Positive or Negative Windfall Graph
Windfall/Surprise
6.30
5.25
$/€
1.01
1.22
1.48
-6.50
-7.80

22. Planned for 25,000 students, but 30,000 want to go abroad (Futures)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy $0
Expected cost to buy €30,000,000
$36,600,000
Risk Mgmt Action Taken?
Must buy €25,000,000 for $30,500,000
Actual cost to buy €25,000,000
($30,500,000)
Actual cost to buy €5,000,000 more in Spot Market
($5,050,000)
($6,100,000)
($7,400,000)
Total Windfall
$1,050,000
($1,300,000)

23. Positive or Negative Windfall Graph
Windfall/Surprise
1.05
$/€
1.48
1.01
1.22
-1.30

24. Planned for 25,000 students, but 30,000 want to go abroad (Options)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy
($1,525,000)
Expected cost to buy €30,000,000
$36,600,000
Risk Mgmt Action Taken?
Let Option Expire. Buy at Spot
Exercise Option for $1.22
Actual cost to buy €25,000,000
($25,250,000)
($30,500,000)
Actual cost to buy €5,000,000 more in Spot Market
$1.01 = ($5,050,000)
$1.22 = ($6,100,000)
$1.48 = ($7,400,000)
Total Windfall
$4,775,000
($2,825,000)

25. Positive or Negative Windfall Graph
Windfall/Surprise
4.78
3.73
$/€
-1.53
1.01
1.22
1.48
-2.83

26. Which to choose?
No Hedge
Futures
Options

27. Cost of Risk Mgmt Strategy
Planned for 25,000 students, but only 10,000 want to go abroad (Do Nothing)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy $0
Expected cost to buy €10,000,000
$12,200,000
Risk Mgmt Action Taken?
N/A
Actual cost to buy €10,000,000
($10,100,000)
($12,200,000)
($14,800,000)
Total Windfall
$2,100,000
($2,600,000)

28. Positive or Negative Windfall Graph
Windfall/Surprise
6.30
5.25
2.10
$/€
1.01
1.22
1.48
-2.60
-6.50
-7.80

29. Planned for 25,000 students, but only 10,000 want to go abroad (Futures)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy $0
Expected cost to buy €10,000,000
$12,200,000
Risk Mgmt Action Taken?
Must buy €25,000,000 for $30,500,000
Actual cost to buy €10,000,000
($30,500,000)
Value of any “unused” Euros
$1.01 = $15,150,000
$1.22 = $18,300,000
$1.48 = $22,200,000
Total Windfall
($3,150,000)
$3,900,000

30. Positive or Negative Windfall Graph
Windfall/Surprise
3.90
$/€
1.01
1.22
1.48
-3.15

31. Planned for 25,000 students, but only 10,000 want to go abroad (Options)
Strong Dollar
Stable Dollar
Weak Dollar
$1.01/€
$1.22/€
$1.48/€
Cost of Risk Mgmt Strategy
($1,525,000)
Expected cost to buy €10,000,000
$12,200,000
Risk Mgmt Action Taken?
Let Option Expire. Buy at Spot
Exercise Option for $1.22
Actual cost to buy €10,000,000
($10,100,000)
($12,200,000)
($30,500,000)
Value of any “unused” Euros
None
$1.48 = $22,200,000
Total Windfall
$575,000
$2,375,000

32. Positive or Negative Windfall Graph
Windfall/Surprise
2.38
0.58
$/€
1.01
1.22
1.48
-1.53

33. Which to choose?
No Hedge
Futures
Options