Hedging Currency Risk at AIFC HBS Case Fin

Hedging Currency Risk at AIFC HBS Case Fin I – SSE MBA

AIFC Business • How does AIFC make money? • 2 divisions – College Division (high risk tolerance, Summer business, low volume - high margins, decisions are done by student/family) – High School Division (low risk tolerance, all-year business, high volume-low margins, decisions are done by administrators) • Reputation – Role of price guarantee • Why AIFC choose to bear the risk?

Sources of underlying risk • The desire for fixed prices and price-setting way in advance of expenses • What is their business? • Customers ($)→AIFC → € → Suppliers • AIFC is (naturally) long in $ and short in € • What are other businesses that are naturally short/long currency?

Sensitivity in base case • Let us exploit 3 possibilities – Unhedged – 100% hedging with forwards – 100% hedging with options • Assumptions: 25, 000 customers, € 1000/head

100% hedging with forwards • No risk/windfall Bank € 25=$30. 5 AIFC Suppliers € 25

Hedging with options • Buy call options at $1. 22. • Cost (in the case) 5% of $ notional value. • So, at-the-money at expiration option will cost 0. 05 $30. 5 m=$1. 525 m

Combining options and futures

What is the best hedging strategy? • Futures – – Greatest consistency No upside/downside No speculation Options are expensive… • Futures+options • Options • What if there is volume risk? For now we are choosing what we think will happen

Scenario I: Boom • +5000 extra customers • Ho hedging: windfall on strong $: $6. 3 mln, loss on weak $: $7. 8 mln • Hedging with forward under 25 K customers assumptions • Strong $: windfall $1. 05 M, weak $: loss $1. 3 M • Options hedging:

Scenario 2: 9 -11: 10 K customers • No hedging: Strong $: windfall $2. 1 M, weak $: loss $2. 6 M • Forwards: strong $: loss of $3. 15 M – on essentially currency position… weak $: gain of $3. 9 M • Options:

Policy Choice • Now the forward position is the one with greatest exposure! • Options position looks pretty good • As does the underlying position… • You cannot eliminate risk…