Hedging Currency Risks at AIFS Christopher Archer-Lock, London-based controller for student exchange organization American Institute for Foreign Study (AIFS) talked almost daily with his Boston-based counterpart, Becky Tabaczynski, CFO for the groups high school travel division ACIS. On this day in early July, 2004, their daily phone call had been especially invigorating. As often before, they had discussed foreign exchange hedging, an area of key importance for the company. AIFS received most of its revenues in American Dollars (USD), but incurred its costs in other currencies, primarily Euros (EUR) and British Pounds (GBP). The currency mismatch was natural given AIFSs business: it organized educational and cultural exchange programs throughout the world. Two of AIFSs major divisions served American students traveling abroad. The Study Abroad College division, where Archer-Lock was controller and treasurer, sent college-age students to universities worldwide for semester-long programs, and the High School Travel division, whose finances Tabaczynski managed, organized 1-4 week trips for high school students and their teachers. Currency hedging helped AIFS protect its bottom line from damaging exchange rate changes. Using currency forward contracts and currency options (Appendix 1 summarizes currency instruments). AIFS hedged its future cost commitments up to two years in advance. The problem was that the hedge had to be put in place before AIFS had completed its sales cycle, and before it knew exactly how much foreign currency it needed. The dilemma meant that Archer-Lock and Tabaczynski frequently discussed two points. First, what percentage of the expected costs should they cover? Currently, AIFS covered 100%. Second, in what proportions should AIFS use forward contracts and options? Today, Tabaczynski had promised Archer-Lock to put together scenarios for how changes in sales and exchange rates could affect the company. He was eager to see what she meant. AIFS Activities and Business Model Through its family of companies, AIFS sent more than 50,000 students each year on academic and cultural exchange programs worldwide. Founded in the U.S. in 1964 by Sir Cyril Taylor (HBS MBA 1961) the group had annual revenues close to $200 million. Two of the groups main divisions focused on Americans traveling abroad:

The College division organized study abroad programs for more than 5,000 American university-aged students during the academic year (Academic Year and Semester, AYS) or the summer (College Summer School, CSS.) All courses were for academic credit, with most participants traveling to Europe, and a significant portion to the United Kingdom. Countries with study programs included Australia, Austria, the Czech Republic, France, Italy, Russia, South Africa and Spain. The Boston-based High School Travel division had been founded in 1978 as the American Council for International Studies (ACIS) and organized chaperoned educational travel for about 20,000 high school students and teachers annually. The groups traveled on 1- to 4-week educational trips to Europe, China, Mexico, Africa, Australia and the Americas. For most participants, these trips were their first exposure to foreign countries, and so AIFS organized the whole trip: airfare, transportation, hotels, tour manager, guides etc. Overall, the College division had higher margins than the low margin/high volume operations of the ACIS division. ACIS was also more exposed to world events than the College division. High school travelers reacted immediately to news of war, terrorism or political uncertainty. Sales could drop up to 60% on such news. In the last 25 years, four events had led to such drops in ACIS sales: the 1986 terrorism acts, the 1991 Gulf War, the 2001 September 11 attacks and the 2003 Iraq war. AIFS also ran several other programs, such as an Au Pair division which annually placed 4,000 young people in American homes to assist with child care, and the Camp America division, which placed 10,000 young people as camp leaders in USA summer camps. AIFS also arranged Academic Year in America (AYA) for students wanting to study in the U.S. Catalogs, Guarantees and Pricing By and large, AIFSs business was catalog-based. The College division distributed two main catalogs per year (one Summer and one Fall/Spring) and the High School division had one main Fall catalog, with several smaller catalogs distributed throughout the year. A key feature was that AIFS guaranteed that its prices would not change before the next catalog, even if world events altered AIFSs cost base. Although the idea often came up for discussion among AIFS management, it was always agreed that it would be hard to abandon the notion of guaranteed prices. The primary customer base (which was not the students, who changed from year to year, but their teachers and academic advisors) based their loyalty to AIFS on the fact that there would be no price surprises. When pricing the programs, both divisions took into account their cost base, competitive pricing and also the hedging activities. Their pricing schedules were, however, different. College Pricing The College worked on an academic planning year, from July 1 to June 30. Prices for any given year had to be set by June 30 the previous year. This meant that now in early July 2004, Archer-Lock had just finalized the prices for the College divisions Summer 2005 and Fall 2005/Spring 2006 catalogs. During the year, Archer-Lock met regularly with marketing and operations managers, to discuss sales forecasts and events that might affect sales. In addition, these managers put out weekly sales forecasts, on which Archer-Lock could base his hedging activities. High School Travel Pricing Combining tours, seasons and departure gateways, the ACIS catalog contained about 35,000 prices. Tabaczynski set these on a calendar year basis, January to December. One of her main goals was to see that ACIS followed a strategy of slow, but steady price increases year by year. She explained,

We found that if we increased our own prices $200 from one year to another, the market reacted. So to avoid sudden price hikes, we instead raise prices in much smaller amounts, a little each year. Interestingly, if we become $200 more expensive than the competition, our customers dont seem to care. We have a very loyal customer base: over 70% of our teachers are returning customers. Hedging at AIFS At AIFS, Tabaczynski and Archer-Lock used currency hedging to help them manage three types of risk. First was the bottom-line risk, or the risk that an adverse change in exchange rates could increase the cost base. Explained Tabaczynski, Say you have costs of EUR 20 million and that we set our catalog prices at parity with the dollar. Then the dollar goes to 1.30! Were now talking 30% of EUR 20 million Its a move that could take you out of business. Second was the volume risk, since foreign currency was bought based on projected sales volumes, which would differ from final sales volumes. Third was the competitive pricing risk, since no matter how currencies fluctuated, the AIFS price guarantee meant it could not transfer rate changes into price increases. Naturally, the competitive risk was closely link to the other risks, especially the bottom line risk. Hedging activities normally started about six months prior to a main pricing date. For the College division, this meant that hedging normally began in earnest in January. Figure 1 shows a sample timeline for pricing as well as hedging for the College division. Figure 1 College Pricing and Hedging Timeline July 2003 July 2004 July 2005 Sales season for Summer 2005 and Fall 2005 /Spring 2006 Pricing and Hedging for Summer 2005 and Spring 2005 / Fall 2006 Source: AIFS For the High School Travel division, hedging took place throughout the year, matched with various sales deals, but company policy was to hedge at least 25% by December, 40% by the end of March and a full 100% by the pricing date in June. To track current hedges, Archer-Lock produced a daily report of currency rates and currency purchasing. (See Exhibit 1 for a sample daily report.) Archer-Lock explained the report, The report is circulated to a broad group of management, since currency rates and our hedging activity affect many aspects of our business and the issues are widely discussed. The report provides a snapshot of key market rates, both short and long term, alongside progress in our hedging activity. The top part of the report shows exchange rates for currencies, looking up to two years forward to match our catalog planning time scales, plus other data such as interest rates and currency policy guidelines. The lower part of the report shows forecast currency buying needs for the different sectors of the business, plus the percentage of hedging undertaken to date in contracts and options, and the rates achieved. These parameters aremonitored in the light of sales and enrollment projections, market rates, currency policy and timing within the business cycle. Archer-Lock also distributed a monthly report that reviewed currency purchasing and made recommendations for future hedging. (See Exhibit 2 for a sample monthly report.) When purchasing currency, AIFS worked with six different banks, with which it had long-standing relationships. The banks had all granted AIFS lines of credit, based on their own analyses of the business. Without the credit lines, AIFS would have had to deposit funds at each bank to cover its hedging activities. Currently, credit lines came close to $100 million USD. A similar level of deposits would have taxed AIFS considerably, compared to the companys annual turnover of $200 million. The ultimate success of the groups hedging activities depended on the final sales volume and the ultimate market value of USD. Archer-Lock summarized the relationship between these two variables with a two-by-two matrix, that he called the AIFS shifting box. (See Figure 2.) Figure 2 AIFS Shifting Box Actual Sales Volume Compared to Projected Exchange Rate HIGH LOW OUT-OF-MONEY IN-THE-MONEY 1. 2. 3. 4. Source: AIFS Archer-Lock explained, Square 1 means that we bought the currency but we dont need it, because our sales came in below our projections. It is a bad place, especially if we are locked into surplus forward contracts on which we would lose money. Its this box that makes us use options, and not just forward contracts. In square 2, the exchange gain hopefully compensates for the lower sales volume. The gain is larger with forward contracts than with options, since options cost roughly 5% of the nominal USD strike price. In square 3, volume came in higher than expected and so we are short foreign currency. The exchange rate moved out-of-money1 though so we can just buy the extra volume we need, favorably, at spot rate. Finally, we have the tricky square 4, which combines both good news bad news. Our sales came in higher than expected, which is good, but it means that we need more currency. 1 A call option is out-of-the-money if the spot exchange rate is less than the options strike price of the option (and .vice versa for a put option.) An out-of-the-money option will have no value at expiry, and the option holder normally just lets it expire. By contrast, an in-the-money option has an intrinsic value, since there is money to be made from exercising the option. A call option is in-the-money if its strike price is below the spot exchange rate.

9. Bookkeeping. A central company-wide bookkeeping rate will be set, which averages all forward contracts and takes account of period end cash balances. Book adjustments will provide businesses with appropriate individual exchange rates. The impact of spot deals and rolling contracts will be charged to divisions. Option costs will be charged to and budgeted by divisions. FAS 133 valuations and accounting entries will be carried out quarterly. The above principles apply generally. Additional guidance for specific divisions is set out below. ACIS Division 1. Instruments. In order to allow for volume fluctuations, needs for a particular year will usually be covered by a combination of up to 50% of forecast needs in options and the remainder in forward contracts (or structured products with a set worst case rate and no initial option premium). An option premium budget will be set for each financial year. 2. Timing. Estimated currency needs for the next year will be covered by the time of pricing, typically the previous June. The timing of the marketing program requires the following stage deadlines: Amount Cumulative Timing At least 25 % 25% By the end of December At least 15% 40% By the end of March At least 60% 100% By the pricing date in June College Division 1 College Division (AYS and CSS). Estimated needs should generally be hedged 100% through options and forward contracts (or zero premium instruments) against the cash flow forecast by the time pricing decisions are taken in June. This applies to the extent that fees are fixed in June. 2. Proportion. Needs for an academic year will be covered by up to 30% of forecast needs in options and the remainder in contracts (or structured products with a set worst case rate and no initial option premium). 3. Phasing. Cover will be designated to mature in the spring, summer or fall of the relevant year, in order to provide an effective cash flow hedge. Source: Adapted by casewriters from AIFS. Numbers have been disguised for confidentiality.

Answer the following questions (Use as many as possible the relevant numbers and statistics in the case to support your answers).

1. What gives rise to the currency exposure at AIFS? (10 points)

2. What would happen if Archer-Lock and Tabaczynski did not hedge at all? (10 points)

3. 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. (20 points)

4. What happens if sales volumes are lower or higher than expected as outlined at the end of the case? (20 points)

5. What hedging decision would you advocate? (10 points)