Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Exchange Rate Risk and the Northern State University International Studies Office A Case Study ABSTRACT The International Studies Office at Northern State University (NSU) helps

Exchange Rate Risk and the Northern State University International Studies Office

A Case Study

ABSTRACT

The International Studies Office at Northern State University (NSU) helps U.S. students arrange programs to study in other countries and also aids foreign students in coming to NSU to study.1Tuition for study abroad programs is negotiated with the host institutions well in advance of the students' payment, introducing considerable exchange rate volatility risk.This case study requires the reader to assess the potential risk and evaluate possible solutions for hedging the risk.

INTRODUCTION

Steve Blair is the new Director of the International Studies Office for Northern State University (NSU).Last year the program lost thousands of dollars because of exchange rate changes and the university administration is hoping Steve can prevent the same thing from happening this year.It is now December of 2003 and Steve and his staff must have a plan in place by January 2004 when the next advertising campaign to the students begins.

On Monday morning Steve decides to have a discussion with Marilyn Hall, who has been an advisor for NSU's International Studies Office for many years.Because of her experience, she is aware of the many challenges in implementing a successful study abroad program.She has heard many students report a positive life-changing experience.They learn to see their own country through the eyes of others, experience places and events they could never know at home, and make new friends in far away places.

She explains to Steve that the programs generally take one of two forms, either an "exchange" or a "fee payment."In an exchange program, NSU students pay the normal NSU tuition but study abroad at a partner institution.In return, the partner university will send an equivalent number of students to NSU, and they also pay their home-school tuition.This form allows students to use financial aid to pay their tuition.An advantage relative to the fee payment form is that it makes it easier for foreign students to be able to afford to study in the United States.An obvious disadvantage to the exchange format is that each university must have an approximately equal number of students willing and able to study at the partner institution.

In a fee payment program there is no reciprocal attendance agreement between the two universities.NSU students pay a fee negotiated ahead of time by the NSU International Studies Office with the foreign university.This fee is paid to NSU, which then converts it to the foreign currency and remits it to the foreign university.Often, this fee is much higher than NSU students would pay for in-state tuition, and approaches the out-of-state tuition rate.As a result, Marilyn believes it is much more difficult for the NSU International Studies Office to "sell" these programs to students and their parents.The advantage of this system is that it gives NSU students a much larger selection of universities from which to choose.Like the exchange programs, it also allows NSU students to use financial aid to pay tuition.It is the fee payment program that has caused most of the losses for NSU and must be addressed.

THE TIMELINE

In order for students to study abroad, Marilyn must begin the process nearly a year in advance.The timing issue is made more severe when dealing with universities in countries south of the equator, as their academic year does not coincide with those institutions north of the equator.Table 1 shows the approximate timeline for a typical "fee payment" study abroad program between NSU and Maori University (MU) in New Zealand.The numbers reflect what happened in the most recent semester when losses were incurred.

Insert Table 1 about here

There are a number of constraints that affect the timing of the payments.For example, Marilyn reports that about 80% of her study abroad students are using financial aid to pay tuition and fees.However, NSU students cannot get their financial aid checks until NSU classes start in August, a month after they begin attending classes in New Zealand.As a result, the students don't pay NSU until August.Another real-world constraint is that some students never adjust to life in a foreign land.Because they feel homesick or experience culture shock, some end up leaving soon after arrival. As a courtesy, Moari University does not invoice NSU until September based on the number of students then in attendance.Other universities have similar policies.

POSSIBLE SOLUTIONS

In his meeting with Marilyn, Steve was wondering "Why can't we just quote our students a price in New Zealand dollars, and let them deal with the exchange rate?"Marilyn responded that adding another source of uncertainty to the equation might make it even more difficult to attract students to the programs.Students and their parents are rightly concerned about the costs of studying abroad and might not want to commit to a program without knowing the actual tuition cost in advance."How about tacking on a premium to account for the possibility that the exchange rate will go against us?" asked Steve.Marilyn liked this idea a little more, but didn't know how to go about quantifying the amount of exchange rate risk or how to come up with an appropriate dollar premium.In addition, if too large, the premium would significantly increase the cost to the student and make it financially less attractive.

Marilyn placed a call to a finance professor at the NSU College of Business Administration to ask for more input.Professor David Jones explained that in business, exchange rate risk is often hedged by using forward contracts, options hedges, or money market hedges.However, in order to hedge, the number of students attending the program would need to be known."Unfortunately, we don't know that number until September, many months after we have quoted a price in U.S. dollars to our students," replied Marilyn."This issue is a lot more complex than I had realized," she thought.They both decided they could estimate the number of students who might go to other countries based on past trends.They would not be able to get a perfect hedge but could at least prevent some of the losses they have been experiencing.They are also worried that the university administration may not approve the use of hedging tools.Universities are typically not as willing as businesses to undertake hedging techniques to reduce risk. Therefore, in addition to plans that use standard hedges, they also need a plan that does not include securities-based hedging.

Steve asked Marilyn to investigate possible solutions to the exchange rate issue and to get back to him with her findings.Although, NSU sends students to dozens of countries, they decided to use the fee payment program with Maori University in New Zealand as a test case.What they learn from situation could be applied to programs in other countries.

SUGGESTED QUESTIONS FOR THE DIRECTED VERSION (Omit for non-directed version).

1.Using the supplied exchange rate data (Appendix A), determine the price of the exchange program in $U.S. at each of these points on the Table 1 timeline.

a. August 2002 (price negotiated)

b. January 2003 (advertised price determined)

c. September 2003 (NSU pays foreign university at current exchange rate).

2.Determine the profit or loss to NSU on a per-student basis as a result of exchange rate volatility from the previous year.Keep in mind that NSU must pay MU the price (in $N.Z.) agreed upon in August 2002.Students will pay the "advertised price" to NSU in $U.S.The cost to NSU in $U.S. will be based upon the exchange rate in September 2003.

3.Develop three alternatives for hedging the exchange rate risk, and discuss the relative strengths and weaknesses of each. Specifically set up:

a. A forward contract hedge.The forward exchange rates, entered in January for delivery in September, are given in Appendix A.

i.Which party (NSU or the student) should bear the cost of this hedge?

b. A money market hedge.The annual interest rates for money deposited or invested in each country are given in Appendix A.

i.Where will NSU obtain the funds to be deposited?

c. An option hedge.Information for both calls and puts are given in Appendix A.The premiums presented are the cost (in $N.Z.) as a percentage of the amount of $N.Z. to be hedged.

4.As explained earlier, the number of study abroad students who will be attending is not known on the date the price is set in $U.S.How would this affect your ability to implement the hedging strategies described above?

5.Given that Marilyn and Steve are worried that the university administration may not approve the use of hedging tools, develop a plan that will help prevent NSU from repeating large past losses without using any of the hedging techniques in item 3 above.Hint: Could a risk premium (i.e. an increase in the advertised tuition over and above that computed at the January exchange rate) be fashioned using the histogram shown in Appendix A?What are the pros and cons of your alternative method relative to the more standard methods?

6.Make a recommendation to the International Studies Office for hedging its exchange rate risk.In your recommendation, rank each of the four methods from items 3. and 5. above.

Table 1.Fee Payment Timeline

August

2002

January

2003

July

2003

August

2003

September

2003

November

2003

NSU and MU negotiate a price of $N.Z. 7,500 per semester.The exchange rate at this time is 0.4635 $U.S./$N.Z.

NSU advertises and recruits students.The advertised price is the $N.Z. 7,500 converted to $U.S.At this time the exchange rate is 0.5398 $U.S./$N.Z.

NSU student begins attending MU.

NSU students pay the advertised price to NSU. At this time the exchange rate is 0.5829 $U.S./$N.Z.

NSU receives an invoice from MU based on actual number of students. NSU pays $N.Z. 7,500 per student at the then current exchange rate of $U.S./$N.Z. 0.5843.

Semester ends at MU.

APPENDIX A.$US/$NZ Exchange Rate Data, Original Scenario.

Exchange rate data is from: http://research.stlouisfed.org/fred2/series/EXUSNZ/15

Table 2.$U.S./$N.Z. Exchange Rate

Month

$U.S. / $N.Z.

Aug-02

0.4635

Sep-02

0.4702

Oct-02

0.4818

Nov-02

0.4973

Dec-02

0.5108

Jan-03

0.5398

Feb-03

0.5539

Mar-03

0.5537

Apr-03

0.5518

May-03

0.5756

Jun-03

0.5815

Jul-03

0.5864

Aug-03

0.5829

Sep-03

0.5843

Figure 1. $U.S./$N.Z. Exchange Rate

Other Information:

i) In January 2003, the 9-month forward rate is .562 $U.S./$N.Z.

ii) The short-term investing rate in the United States is 1.22% and in New Zealand is 5.57%

iii) The short-term borrowing rate in the United States is 1.72% and in New Zealand is 6.12%.

iv) An at-the-money call option with a strike price of .5398 $U.S./$N.Z. has a premium of 2.1% of the $N.Z. amount to be hedged.An at-the-money put option has a premium of 5.2% of the amount to be hedged.

Note: the option premiums presented above were estimated using the Black-Scholes option pricing model.In practice, they would be obtained in an over-the-counter (OTC) transaction.Prices for these OTC transactions are not generally reported to the public.See Appendix C for the calculation.

The data in the table and histogram below can be used to assess the likely changes in the exchange rate for nine-month look-ahead periods.

Table 3.Nine Month Rolling Changes in $U.S.D/$N.Z. exchange rate, 1972-2002

Bin

Frequency

Cumulative %

-30%

1

0.3%

-25%

5

1.6%

-20%

10

4.3%

-15%

14

8.1%

-10%

31

16.4%

-5%

78

37.4%

0%

68

55.6%

5%

73

75.3%

10%

47

87.9%

15%

27

95.2%

20%

12

98.4%

25%

5

99.7%

30%

1

100.0%

Figure 2. Nine Month Rolling Changes in $U.S./$N.Z. exchange rate, 1972-2002

The bin reflects ranges of the observed changes in the exchange rate during the sample period.For example, the table indicates there was only 1 time period in which the $U.S./$N.Z. exchange rate decreased by more than 30% and 68 periods in which the change was between -5% and 0%.

The cumulative data shows that the exchange rate increased by 5% or less in 75.3% of the observed periods.

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Financial Management Principles and Application

Authors: Arthur J. Keown, J. William Petty, David F. Scott, Jr.

10th edition

536514119, 536514110, 978-0536514110

More Books

Students also viewed these Finance questions

Question

Describe the elements of a contract.

Answered: 1 week ago

Question

Name the laws and regulations that affect small business.

Answered: 1 week ago