Hedging Currency Risks at Aifs

Workings:

We have analysed three different scenarios of sales which is 30000, 25000 and 10000 along with three different scenarios of exchange rate which is strong(1.01$/Euro), stable(1.22$/Euro), weak(1.48$/Euro) with the given data (Table 1). In each of the scenarios, we have taken into consideration five covers (100%, 75%, 50%, 25%, 0%) and bifurcated cover into percentage of contract and percentage of options. After computing expected payoffs. We assigned probabilities (Table 2) to each of the scenarios to reach at the total probabilities. Finally, the maximum payoff for each of the probability is chosen as the best hedging strategy. For all the workings kindly, refer to worksheet the Hedging Currency Risk at AIFS workings.                                              

                                                                AIFS Shifting box

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We have created AIFS Box only for the 100% cover wherein we have used 100% options (Refer to the Table 4). In the box 1, the actual sales are 25,000. But, If the exchange rate is in our favour, i.e. strong dollar 1.01$/Euro, there our losses would be confined to the option premium rather than huge losses in case we go for forward contract, however the loss due to option premium would be offset by the gain due to exchange rate gain. So, Option as a hedging instrument is advisable. If the actual sales are as projected, i.e. 25000, and the scenario is of stable dollar, 1.22$/Euro, the data point is plotted at the centre. In this case no hedging is advisable, however, due to uncertainty with respect to both sales and exchange rate movement, it is best to hedge with options. Because, taking 100% option cover will limit the losses till premium cover only.  If the actual sales are more than our projection, the currency rate is in the money, so we can exercise the option and buy at a lower exchange rate than spot rate, the payoff will be higher than other two alternatives (Forward contract and No Hedging).

Results:

We have identified that 100% option cover is best hedging strategy for all scenarios. Please refer to Table 3 for the maximum payoffs in all the scenarios considering all the probabilities.

List of Tables:

Table 1:

Source: HBS Case, Hedging Currency Risk at AIFS