External Hedging Techniques for Managing Foreign Exchange Risk

Currency Accounts and Currency Loans Spot Trading

External Hedging Techniques

Forward Contracts

Currency Options

Currency Swaps

Currency Accounts

Bank accounts set up in foreign currency and work well for companies with regular flow of both payments and receipts in a particular foreign currency. The matched in and out flows help the company avoid having to buy or sell currency for each transaction. Currency loans which means borrowing money in a foreign currency, they work similarly, in that the company can use future income streams in that currency to pay off the loan.

Currency Loans

Spot Trading

Most common foreign exchange transaction. The company will convert foreign currency at todays market foreign exchange rate.

Forward Contracts

Purchase or sale of foreign currency at a specific date in future. It allows companies to fix the exchange rate today for future payments or receipts of foreign currency.
The company has a right but not an obligation to purchase or sell a currency at an agreed exchange rate the strike price. For this right without obligation the buyer of option pays a premium hence making currency options more expensive.

Currency Options

Currency Swaps

These are exchange transactions which take place in real time. The principal and payments of a fixed interest contract in one currency are swapped with principal and payments of an equal loan in other currency.

 What would happen with a 100% hedge with forwards? A 100% hedge with options? Use the forecast final sales volume of 25,000 and analyze the possible outcomes relative to the zero impact scenario described in the case?

Assumptions
Sales volume of 25000 100% hedging policy 3 alternative hedging strategies -Do nothing (no hedge) -100% hedge with forwards -100% hedge with options 3 exchange rate levels for dollar to euro

-Stable dollar (1.22USD/EUR) -Strong dollar(1.01 USD/EUR) -Weak dollar (1.48 USD/EUR)

Cost per student (EUR)

1000 1000

Sales Volume
25000 25000

Spot Rate ($/EUR)

1.01 1.22

Cost
$25,250,000 $30,500,000

1000

25000

1.48

$37,000,000

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. When the dollar is weak compared to the Euro, this creates a negative impact for AIFS by increasing their costs by $6.5 million. According to our viewpoint both the contracts are beneficial. Both contracts have their pros and cons. If we take a variable fluctuations, then if fluctuations are high then its better to opt for option contracts to minimize our risk, but if fluctuations are lower than its better to go for forward contract as to save our 5% premium cost.