Hedging

The American Institute for Foreign Study (AIFS) is an exchange student organization. Two of its major divisions served American students traveling abroad. Thus, AIFS received most of its revenues in USD Dollars but sustained its costs primarily in Euros (EUR) and British Pounds (BP). Due to this currency mismatch, a foreign exchange hedging strategy was discussed as an important key for the company aiming to minimize AIFS’s exposure to unwanted risk. AIFS used mainly currency options and forward contracts as hedging strategies.

With hedging, AIFS came up to manage three types of risk:

1- Bottom-line risk: meaning an adverse change in exchange rates could increase the cost base. Tabaczynski explains that this movement can take you out of the business.

2- Volume risk: AIFS bought the foreign currency based on forecasted sales volumes. In case the sales volume increases, costs will increase as well which are subject to currency risk as they were not hedged.

3- Competitive pricing risk: AIFS guaranteed that rate changes could not affect price.

Archer-Lock (London-based controller for student exchange) and Becky Tabaczynski (CFO of group’s high school travel division) were concerned about two scenarios:

a- what expected costs should they cover?

b- In what proportions should AIFS use forward contracts and options?

Conclusion

Technically, to hedge, AIFS should invest in two securities with negative correlations. Of course, nothing in this world is free, so it still has to pay for this type of insurance in one form or another. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.