These two questions is what I will present, and please read through the case first then answer these two questions. Thank you!

1. Suppose you expected the dollar to appreciate in value by 10% against the euro during the next 9 months. Given your proposed hedging policy, would you still hedge 100%of MSU's anticipated euro expenses? If not, how much would you hedge?

2.How you would implement a hedging program at MSU? What controls would you impose so that the Office of Study Abroad does not make a silly-but-possibly-catastrophic mistake in implementing its currency risk management program?

Managing exposures to currency risk at Michigan State University Kirt C. Butler August 2013 Managing exposures to currency risk at Michigan State University Winston Churchill once said \"When I look back on all these worries I remember the story of the old man who said on his deathbed that he had had a lot of trouble in his life, most of which never happened.\" As he lingered over his morning coffee, Brett Berquist was inclined to agree with Churchill's observation. Brett's position as Director of the Office of Study Abroad at Michigan State University (MSU) meant that he had plenty to worry about - including students' health and safety, the impact of local and global political turmoil on MSU students traveling abroad, and the hopes, fears, and expectations of their families back home. Study abroad programs have grown in popularity around the world as students, faculty, and administrators at educational institutions strive to achieve world-class knowledge and experience of international affairs. Michigan State University is a leader in this field, and Brett was in charge of the largest study abroad program at a U.S. public university.1 Based in East Lansing, Michigan, MSU has nearly 300 study abroad programs spanning a wide range of academic disciplines in more than 60 countries and on all seven continents, ranging from the Arctic Circle to Antarctica.2 Close to 3,000 MSU students participate in study abroad programs each year. MSU's success in study abroad meant that it had significant exposure to a number of foreign currencies as it paid for accommodation, transportation, and related expenses for its study abroad programs. MSU's largest foreign exchange (FX) exposures were in the euro, the British pound, and the Australian dollar. MSU's academic year extended from September through August. Summer study abroad experiences were by far the most popular and most foreign currency expenditures were paid during the summer semester running from May through August. Annual expenditures in these currencies during 2011 and their dollar values (translated at the exchange rates that prevailed on the dates of the expenditures) are shown in Exhibit 1. Currency Euro British pound sterling Australian dollar Total Exhibit 1 MSU's Top Three Currency Exposures Foreign currency Dollar value of Average FX rate expenditures expenditures during 2011 871,196 $1,194,336 $1.3709/ 617,612 $992,851 $1.6076/ A$868,133 $886,315 $1.0209/A$ $3,073,502 - Expenditures during 2013 were not yet available, although they were thought to be about the same as in 2011 and 2012. MSU had about $1 million of expenditures in other currencies, primarily in the Chinese yuan, the Japanese yen, the South African rand, and the New Zealand dollar. MSU separated study abroad program budgets into two separate accounts - tuition and a program fee - in order to create budgets that reflected actual costs. Tuition - Tuition for courses used in the study abroad programs was charged at the same rate as for on-campus courses. These expenses were billed in dollars, so MSU had no exposure to currency risk in this account. A portion of this tuition was transferred back to the Colleges to support instructional expenses such as faculty salaries. Program fee - All remaining expenses were bundled into a program fee charged at the time students paid their tuition for the program. The fee included hotel expenses, transportation, and any related expenses incurred on the program. Some programs included student airfare in the program fee, although airfare was paid in dollars and hence not exposed to currency risk. MSU's portfolio of study abroad programs was relatively stable, and foreign currency expenses also had been fairly constant during the last several years. There was some turnover in programs, but as some programs This case is developed solely as a basis for classroom discussion and is not intended to illustrate best - or worst - management practices. Some details have been modified for pedagogical purposes. 1 Institute of International Education (iie.org/). 2 MSU \"Study Abroad Fact Sheet\" (studyabroad.isp.msu.edu/about/). 1 Managing exposures to currency risk at Michigan State University disappeared others often arose to take their place. For this reason, future foreign currency expenses were expected to be similar to current levels. MSU's actual dollar exposures fluctuate with the value of the dollar against foreign currencies. MSU had little need for currency risk management aside from its study abroad programs because the revenues and expenses in its $1 billion annual budget were otherwise mostly in dollars. Study abroad programs through the Office of Study Abroad were the most important - and the most predictable - of MSU's foreign currency exposures. Brett's boss (MSU's Office of the Provost) was as concerned about charging too much as too little for MSU's study abroad programs. Brett's directive was to get program pricing \"exactly right\" as this was the only fair outcome for all involved. As a public institution, MSU didn't want to make money on its study abroad programs - but Brett couldn't afford to lose money either. OPERATING VERSUS TRANSACTION EXPOSURES TO CURRENCY RISK AT MSU Currency exposures can be categorized as operating or transaction exposures. Operating exposure refers to changes in the value of operating or noncontractual cash flows due to unexpected changes in exchange rates. Transaction exposure refers to changes in the value of contractual cash flows (transactions) due to unexpected changes in exchange rates. The nature of MSU's currency risk exposures recently had changed from an operating exposure to a transaction exposure. When Brett accepted his position in 2009, study abroad programs were being priced just prior to departure. This caused unacceptably high cancellation rates whenever a foreign currency appreciated, as the dollar prices of programs in that country were adjusted upward to reflect the increase in the foreign currency value. Conversely, MSU's study abroad programs in that country tended to be oversubscribed when a foreign currency depreciated in value - and not all students could be accommodated on the most popular programs. Not knowing how many students would participate in study abroad created uncertainty for MSU's administrators and for the faculty leaders of the programs, and often resulted in unexpected costs when additional overseas accommodations were cancelled or sought. Brett judged that this operating exposure to currency risk was unacceptable, and looked for a way to mitigate this risk. In order to reduce MSU's operating exposure to currency risk, Brett instituted a policy of pricing summer programs in the previous September so that students, faculty, and administrators would know what costs to expect on their programs (see Exhibit 3 and Appendix A). This pricing policy facilitated administration and execution of the programs by reducing the impact of fluctuations in exchange rates on program participation. However, the fact that most expenses were not incurred until the programs were run the following summer created a transaction exposure to currency risk. Exhibit 2 Pricing Timeline for MSU's Summer Study Abroad Progams Initial pricing in the Students' commitment Summer previous September deadline in February study abroad | programs | | | | | | | | | | | | | | Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug | MSU's academic year runs from September through August | Even with the new pricing policy, MSU did not know the exact amount of its foreign currency expenses at the time of the February deadline for students to commit to a study abroad program. In addition to foreign currency considerations, unexpected man-made and natural disasters - such as the 2005 London public transit bombings and the 2011 tsunami in Japan - often caused enrollments on programs in troubled locations to unexpectedly decline. Brett was considering whether to hedge the full amount of his anticipated exposures or to hedge only a portion of that amount in case student participation fell below expectations. Based on conversations with his staff, Brett estimated there was a 10 percent chance of participation falling 10 percent below expectations in any given year and in each currency. Brett was less concerned about foreign currency expenses rising above 2 Managing exposures to currency risk at Michigan State University expectations, as most foreign currency expenses were contractual obligations that were determined prior to departure in the foreign currencies. Exhibit 3 MSU's short euro exposure MSU's underlying transaction exposure MSU's risk profile in levels V$/ $1.30/ MSU's risk profile in percentage changes S$/ v$/ 900,000 Actual expenditure at S$/ = $1.30/ = (-900,000)($1.30/) = -$1,170,000 s$/ -$1.30/ A 1% change in S$/ results in a -1% change in V$/ MANAGING MSU'S EXPOSURES TO CURRENCY RISK In order to clarify his thoughts, Brett focused his analysis on MSU's euro exposures. This was relatively straightforward because euro expenses were concentrated in the summer months. The timing of MSU's expenses in British pounds and Australian dollars were a bit more problematic because they were not so concentrated in the summer months. In August of 2013, Brett expected foreign currency expenses in summer 2014 to be slightly more than in 2013. For the euro, Brett predicted a 2013 exposure of about 900,000. The dollar values of MSU's euro obligations change with the value of the euro according to P$ = PS$/, where S$/ is the dollar value of the euro, P is a contractual euro cash flow (i.e., expense), and P$ is the dollar value of the cash flow. For example, a summer 2014 obligation of 900,000 would cost P$ = PS$/ = (900,000)($1.30/) = $1,170,000 at an exchange rate of S$/ = $1.30/. If the value of the euro rose by 10% from $1.30/ to $1.43/, MSU's dollar obligations would rise in value by 10% to P$ = PS$/ = (900,000)($1.43/) = $1,287,000. The dollar value of MSU's euro obligations is a form of financial derivative in that the dollar value of the euro exposure is derived from the value of the euro according to P$ = PS$/. Exhibit 3 illustrates MSU's euro exposure by graphing the dollar-per-euro value of MSU's expected expenses against the dollar-per-euro spot rate of exchange. Every one cent increase in the value of the euro increases the dollar value of MSU's euro expenses by one cent. Similarly, a one percent increase in the value of the euro increases the dollar value of MSU's euro expenses by one percent. THE INTERNATIONAL PARITY RELATIONS AND SPOT RATE VOLATILITY In order to determine how much MSU might gain or lose on its currency exposures, Brett needed an estimate of the likely changes in exchange rates over MSU's 9-month forecasting horizon. That is, he needed an estimate of exchange rate volatility or the standard deviation of return to these currencies. Expectations of future currency values and their volatilities should be grounded in the international parity conditions that relate exchange rates to interest rates in various currencies. These relations are introduced in this section and summarized in Exhibit 4. Covered interest parity Forward parity Uncovered interest parity International Fisher relation Relative purchasing power parity Exhibit 4 The International Parity Conditions Ft$/f / S0$/f = [(1+i$) / (1+if)]t Ft$/f / S0$/f = E[St$/f] / S0$/f E[St$/f]/ S0$/f = [(1+i$) / (1+if)]t [(1+i$) / (1+if)]t = [(1+p$) / (1+pf)]t E[St$/f] / S0$/f = [(1+p$) / (1+pf)]t 3 Managing exposures to currency risk at Michigan State University The International Parity Conditions A spot exchange rate is the price of one currency in terms of another currency on a spot date. For example, the spot rate S0d/f is the value in currency d of one unit of currency f for immediate exchange. Conversely, the spot rate S0f/d = 1/S0d/f is the value in currency f of one unit of currency d. A forward exchange rate Ftd/f = 1/Ftf/d reflects the relative values of currencies d and f for exchange on a specified future date. The relation between spot and forward exchange rates depends on relative interest rates in the two currencies and is called covered interest parity (or interest rate parity). Consider the value of one unit of a foreign currency f in terms of dollars. Covered interest parity requires that Covered interest parity $/f, Ft$/f / S0$/f = [(1+i$) / (1+if)]t Ft$/f, (1) for a spot rate S0 a forward rate and riskless nominal interest rates and The covered interest parity relation says that the forward premium or discount (Ft$/f/S0$/f) depends on the relative level of nominal interest rates [(1+i$)/(1+if)]t in the two currencies. Alternatively, the forward premium or discount on the left side of the relation depends on the relative opportunity cost of capital on the right side of the relation. Financial market arbitrage ensures that this relation holds at all times within the bounds of transactions costs, because each of these prices is actively traded in international markets. This is an international parity relation that Brett can trust. Speculative market activity suggests that forward exchange rates should predict future spot exchange rates. Forward parity i$ Ft$/f / S0$/f = E[St$/f] / S0$/f if. (2) This forward parity relation is driven by speculative activity of in the financial markets. If someone expects the spot rate St$/f at time t to be above the forward rate, then they can buy currency f at the forward price Ft$/f with the hope of selling it at their expectation E[St$/f]. Conversely, if they expect the spot rate to fall below the forward price at time t, then they can sell f forward with the hope of buying it back at a lower price. At the margin, this speculative activity should result in forward rates predicting future spot rates. This relation holds relatively well for forecast horizons that extend out several years. The relation is not as predictive over Brett's 9-month forecast horizon because the 'signal' in the forward parity relation is not very strong relative to the 'noise' or volatility from unexpected changes in exchange rates (see below). If forward exchange rates are good predictors of future spot rates, then interest differentials in Equation (1) also should predict future spot rates. This relation between expected changes in the spot exchange rate and the interest differential is called uncovered interest parity. Uncovered interest parity E[St$/f] / S0$/f = [(1+i$) / (1+if)]t (3) This is covered interest parity in Equation (1) without the \"cover\" of the forward transaction. Uncovered interest parity holds more predictably over longer forecasting horizons - just like the forward parity relation in Equation (2). According to the Fisher relation, nominal interest rates are composed a real rate and an inflation expectation E[p]. Fisher relation (1+i) = (1+real interest rate)(1+E[p]) (4) In this framework, a real interest rate is an inflation-adjusted interest rate; a nominal interest rate that has had inflation (or expected inflation) removed. The international Fisher relation posits that real interest rates on a particular asset should be equal across currencies, so that investors can expect to earn the same inflation-adjusted return. Hence, cross-currency differences in nominal interest rates are driven by cross-currency differences in expected inflation. International Fisher relation (1+i$)/(1+if) = (1+E[p$])/(1+E[pf]) (5) Like forward parity, this relation does not hold very well over Brett's forecast horizon. Real required returns across different currencies often are out of equilibrium, and as a consequence real interest rates cannot cancel one another from the left-hand side of Equation (5). The International Fisher relation is a better fit over long-term horizons. Finally, expected inflation differentials should have an impact on actual spot rates of exchange. This impact is captured by relative purchasing power parity. Relative purchasing power parity E[St$/f] / S0$/f = (1+E[p$])/(1+E[pf]) 4 (6) Managing exposures to currency risk at Michigan State University This parity relation states that a currency with high inflation relative to another should lose its value proportionately - at least in the long run. Conversely, a currency with relatively low inflation eventually should lose value. Like forward parity, this relation does not hold very well over 9-month forecast horizons. It can take several years for inflation differentials to have an impact on exchange rates. In the end, inflation differentials eventually prevail. Exchange Rate Volatility and Its Consequences Prior to his career in educational administration, Brett had enjoyed a 13-year teaching career in business schools in England, France, and the United States. However, his formal training was in linguistics and he was unsure of how to analyze FX movements and comovements and their impact on MSU. But it didn't take a degree in Finance for Brett to realize that his unit's gain or loss depended on the size and direction of FX movements against the dollar. A straightforward way to estimate currency volatility (i.e., the standard deviation of currency returns) is to calculate a historical volatility based on past changes in currency values. To begin, Brett downloaded month-end FX rates for the euro, pound, Australian dollar, and Japanese yen from the oanda.com website (see Appendix B) since the introduction of the euro in December of 1998. His intention was to calculate currency returns (1+st$/f) = (St$/f/St-1$/f), volatilities , and cross-currency correlations. MSU had about $0.5 million in yen expenses through study abroad programs in Japan during 2011, so Brett included the yen in his table. Brett first calculated dollarper-foreign exchange rates as the reciprocals of the foreign-per-dollar exchange rates in Appendix B; that is, as St$/f = 1/Stf/$. He then calculated the standard deviation of percentage changes in the dollar-per-euro exchange rate as 1 = 3.14%. This suggested euro volatility was about 9 = (9)(3.14%) = 9.42% over his 9-month forecast horizon.3 A popular alternative estimate is implied volatility in which volatility is inferred from publicly traded currency option prices. Implied volatility has the advantage of being both market-based and forward-looking. In August of 2013, Bloomberg's \"EURUSDV9M\" volatility index for the dollar-per-euro exchange rate over a 9month forecast horizon was 8.55 percent per year. The implied volatility estimate over Brett's 9-month horizon is 9 = 7.40%.4 Value-at-risk (VaR) is a popular method for assessing the consequence of risk exposures by estimating potential losses due to adverse price movements in the price of an underlying asset with a certain level of confidence and over a certain time horizon. For example, a bank might estimate that there is a 5 percent probability of losing more than 20 percent of a loan portfolio's value over the next year. International banks commonly report VaR estimates in their financial reports in response to calls for increased disclosures of banks' risk exposures. There is evidence that these disclosures are indeed informative in that they predict subsequent variability in banks' revenues. VaR is often criticized because applications based on the normal distribution underestimate the probability of extreme negative events and fail to account for correlated default; that is, the tendency of asset prices to fall in unison. Such events can have a disproportionate impact on financial institutions and the viability of the international financial system. Indeed, a major point of emphasis in Basel III is to foster the use of risk assessment tools that recognize the existence of correlated defaults. To this end, many contemporary applications of VaR eschew the normality assumption for models that incorporate fatter-than-normal tails and higher-thannormal comovements in the tails of the return distribution. HEDGING ALTERNATIVES Best practice in industry is to offset positive and negative exposures within an enterprise whenever possible; that is, to offset foreign currency cash inflows with foreign currency cash outflows. However, MSU's international activities generated far more foreign currency expenses than receivables. Moreover, currency exposures outside the Office of Study Abroad were not consolidated into a single campus unit and varied in magnitude from year to The relation between T-period and 1-period volatility is T = (T)1 for independent and identically distributed normal (or Gaussian) returns. An approximation of 9-month volatility is then T = (9)(3.14%) = 9.42%. 4 Following the logic of the previous footnote, = (T) = [(9/12)] = (0.8660)(8.55%) = 7.40%, where 9 1 12 12 represents 12-month (annual) volatility. 3 5 Managing exposures to currency risk at Michigan State University year. MSU also could not rely on cross-currency diversification within its portfolio of study abroad programs, because the dollar typically rose or fell against most foreign currencies in the same direction in any given year. Without a way to offset foreign currency cash flows internally, Brett and his team considered three external financial market hedges for managing MSU's exposures to currency risk: currency forwards, currency futures, and currency options. Currency Forwards In a currency forward contract, currencies are traded for future delivery according to an agreed-upon delivery date, exchange rate, and amount. Gains or losses on currency forwards are settled at maturity when currencies are exchanged. Currency forward contracts are offered by commercial and investment banks and other financial service providers. Financial market arbitrage ensures that forward exchange rates are equal to spot exchange rates adjusted for the relative opportunity cost of capital in the two currencies.5 MSU uses Western Union for its currency transactions. Western Union quotes forward exchange rates with a bid-ask spread nearly identical to the bid-ask spread on the spot rates that MSU had been using to settle its foreign currency transactions. Competitive bid-ask spreads on forward currency contracts are possible because of high volume and liquidity in these markets. Indeed, only 38 percent of the $5.34 trillion daily volume in the interbank currency market is conducted in spot exchange, with the remainder in outright forwards and currency swaps.6 Currency forward contracts provided MSU with a flexible and effective way to manage their currency risk exposures. Brett could hedge MSU's 900,000 forward obligation by buying 900,000 at the forward exchange rate of $1.30/. Ex ante, a euro forward contract is a zero-NPV transaction as the value of the dollar cash inflow exactly offsets that of the euro cash outflow at the forward exchange rate. Ex post, the gain or loss on the euro forward contract would exactly offset the loss or gain on the underlying euro exposure. The short euro underlying exposure and the long euro forward hedge are shown in Exhibit 5, along with the combined or hedged position. Exhibit 5 MSU's long euro forward hedge Forward hedge Short euro exposure V$/ -900,000 $1.30/ v$/ S$/ Long euro forward Hedged position +900,000 Forward hedge s$/ -$1,170,000 Forward hedge: Sell 900,000 9-months forward at Ft$/ = $1.30/ Hedged position -$1.30/ Euro exposure Euro exposure Regardless of the spot exchange rate at expiration, Brett will have locked in a cash inflow of 900,000 through the forward contract to offset his 900,000 in expected expenses. The $1.170 million cash outflow on the other side of this forward position could then be passed along as a dollar-denominated program fee to students participating in MSU's study abroad programs in the Eurozone. Western Union's standard contract called for clients to maintain a compensating balance in order to ensure settlement of forward transactions, but this requirement usually was waived for a client of MSU's creditworthiness. 5 6 From covered interest parity, Ft$/f/S0$/f = [(1+i$)/(1+if)]t. Bank for International Settlements \"Triennial Survey,\" April 2013, bis.org. 6 Managing exposures to currency risk at Michigan State University Currency Futures Like currency forward markets, currency futures markets in major currencies are highly liquid with competitive pricing and costs. Currency futures are standardized contracts that trade on financial exchanges as well as overthe-counter through financial service providers such as investment banks. Currency futures differ from forwards in that gains and losses from currency fluctuations are settled or marked-to-market on a daily basis rather than at maturity. Futures also require margin accounts that serve as a form of safety deposit to assure settlement of daily gains and losses. Aside from these contractual differences, currency futures are used for hedging in much the same way as currency forward contracts. Contract sizes on the Globex Electronic Market of the Chicago Mercantile Exchange are 125,000, 62,500, and A$100,000. Several institutional factors at MSU made the use of currency futures contracts difficult. MSU's Controller had no experience with margin accounts on futures contracts and had neither the time nor the inclination to manage them. Brett also would have needed permission from MSU's Board of Trustees to contract with a new financial service provider because Western Union (MSU's current financial service provider) did not offer currency futures contracts. Moreover, Brett had more important global initiatives on his agenda and didn't want to waste his or the Board's time with a request for a new financial services provider just for MSU's study abroad activities. Besides, MSU conducted many of their external transactions through Western Union, and Western Union was quoting very competitive bid-ask spreads for currency forward contracts because of this existing relationship with MSU. Currency Options MSU's client manager at Western Union encouraged Brett to consider currency options, stating that many corporate clients preferred option hedges. Currency options provide the right to buy or sell foreign currency at a specified exercise (or strike) price and on or before a specified exercise (or maturity) date. The seller (writer) of the option contract has the obligation to fulfill the other side of the contract. Currency options can provide a \"disaster hedge\" or insurance against unfavorable currency movements by offsetting losses beyond the exercise price of the option. Brett could hedge his euro obligations by buying a euro call option that provided him with the option to buy 900,000 at an exercise price and on an exercise date that could be negotiated with Western Union.7 The premium (or price) of a currency option depends on six factors: the spot rate, the option's exercise price, domestic and foreign risk-free interest rates, the option's time to expiration, and the volatility of the spot exchange rate. At current interest and exchange rates, the option premium on a euro call with an exercise price of $1.30/ and an exercise date nine months in the future was approximately $0.0381/.8 Exhibit 6 displays the payoffs on this long euro call option hedge. The euro call option protects against the exchange rate closing above the $1.30/ exercise price. If the exchange rate closes above $1.30/, the gain from buying euros at the below-market exercise price of $1.30/ would offset losses on the underlying short euro exposures. This would ensure that program costs would not exceed $1.30/, or a total cost of (900,000)($1.30/) = $1,170,000. The cost of buying this insurance would be the amount of euros covered by the hedge times the option premium, or (900,000)($0.0381/) = $34,295. This option premium would be due from MSU to Western Union at the time the hedge was initiated. Including this option premium in students' program fees would add (34,295)/(900,000) ($0.0381/)/($1.30/) 2.93 percent to students' program costs. Brett was concerned with how to allocate the costs and benefits of an option hedge to the students. In particular, including the cost of a euro hedge in students' program fees but not rewarding students when the euro fell in value (and call option hedges expired unexercised) would benefit MSU at the expense of the students. One Conversely, expected cash inflows of foreign currency can be hedged with currency put options, which are options to sell the underlying currency at prearranged exercise prices and exercise dates. 8 The option premium is $0.0381/ given a spot rate of $1.30/, an exercise price of $1.30/, annual interest rates of 1 percent in dollars and in euros, a 9-month time to expiration, and annual volatility of 8.55 percent. See Biger and Hull, \"The Valuation of Currency Options,\" Financial Management, Spring 1983. 7 7 Managing exposures to currency risk at Michigan State University Exhibit 6 MSU's long euro call option hedge at an exercise price of K$/ = $1.30/ Call option hedge V$/ Short euro exposure 900,000 Option hedge: A long euro call with a contract size of 900,000, an exercise price of K$/ = $1.30/, maturing in nine months, and selling for an option premium of $0.0381/. $0.0381/ $1.3381/ $1.3000/ S$/ Hedged position Underlying euro exposure alternative would be to return a partial refund of program fees if the exchange rate fell below some threshold (e.g., $1.20/). This would send a positive signal to students and their parents while insuring MSU and the students against adverse currency movements. Although such a hedge might be common in a corporate setting, Brett worried that such a refund program would be time-consuming and costly to implement at MSU. He also was unconvinced that currency options provided an appropriate hedge given MSU's objective of reducing its transaction exposure to currency risk. These considerations were pushing Brett toward thinking that it would be simpler to hedge with currency forwards, rather than deal with the asymmetry of a currency option hedge. INSTITUTIONAL CONSIDERATIONS Brett needed to consider his alternatives in light of the institutional setting at Michigan State University. He knew that he needed a currency hedging plan that reflected MSU's objectives and was feasible given the institutional setting. Internal Institutional Constraints Brett felt that senior administrators at MSU would be receptive to a well-conceived currency risk management program. MSU's chief financial officer in particular was knowledgeable and experienced in this specialized area of finance. However, MSU's rank-and-file administrative staff had very little experience in foreign exchange because the vast majority of MSU's operations were in dollars. Indeed, Brett's $4 million currency exposure represented only 0.4 percent of MSU's $1 billion annual budget. Moreover, Brett would have to allocate currency risk management responsibilities across an already overworked staff. Managing the program would impose significant costs in terms of managerial time and effort. One of these costs would be conforming to the regulatory requirements of the 2010 Dodd-Frank Wall Street Reform and Consumer Act. The Dodd-Frank Act introduced an \"external business conduct\" rule to promote safe and transparent documentation of derivatives trades. By 2013, the U.S. Commodity Futures Trading Commission (CFTC) had created a protocol for satisfying the external business conduct rule that required financial derivatives users such as MSU to satisfy a set of protocols describing the terms of trade and dispute resolution processes with their financial service providers.9 Although the intent of the Dodd-Frank Act was to ensure safe and transparent derivatives trades, an unfortunate side effect was an increase in the time and effort that MSU needed to devote to its risk management program. The size of Brett's currency exposure relative to MSU's budget and the lack of resources that he could direct to a currency risk management program were important institutional constraints at MSU. The managerial costs of Western Union suggested that MSU use \"ISDA Amend\" (markit.com/isda-amend), a joint service of Markit (markit.com) and the International Swaps and Derivatives Association (isda.org). 9 8 Managing exposures to currency risk at Michigan State University a complicated risk management program would quickly outweigh the potential benefits of the program. Brett needed a currency risk management program that would be simple, transparent, and inexpensive to implement. Agency Considerations Although Brett's #1 job was to manage the university's portfolio of study abroad programs, he was acutely aware that he needed to manage his own career as well. Brett knew that any actual or perceived problems in MSU's study abroad programs would be attributed to his stewardship of the Office of Study Abroad. MSU's currency exposures presented him with a \"damned if you do, damned if you don't\" dilemma. If he didn't hedge and exchange rates rose, some within the institution might blame him for failing to manage the currency risk exposures of his study abroad programs. If he did hedge and exchange rates fell, then his Monday-morning critics could ask why he hedged. A saving grace was the Provost's directive to get program pricing \"exactly right\". Brett's objective in hedging currency risks wasn't to make (or lose) money, but merely to manage the currency risk exposures of these programs. This eliminated many of the agency considerations found in private industry, because the objectives of all stakeholders (including Brett, MSU's Provost, students, program leaders, and administrators) were to manage risks rather than to seek profits. To this end, Brett decided that he needed a policy statement that would outline the program and its motivation in a transparent way and provide a defense against institutional second-guessing. Brett had been involved in study abroad programs at various educational institutions for more than 20 years and realized that most of the administrative staff at this large public university had little experience in currency risk management. He'd need to think carefully and creatively about how he should proceed. 9 Managing exposures to currency risk at Michigan State University Case Questions It is the end of August of 2013 and Brett is considering how to manage his foreign currency exposures for his portfolio of summer 2014 study abroad programs. In order to focus his thoughts, he is concentrating his numerical examples on his expected euro exposure of 900,000. The current spot rate of exchange is $1.30/. This is about the same as the 9-month forward exchange rate because interest rates in dollars and euros are roughly the same. 1. Answer the following questions about the appropriate hedging policy for MSU. - What objective is appropriate for MSU's currency risk management program? Why? - Given this objective, should Brett adopt an active FX risk management program that takes a view and attempts to profit from FX rate changes or a passive program that does not try to time the market? - How should Brett evaluate the performance of a FX hedging program? Against what benchmark should performance be evaluated? 2. Answer the following questions about the nature of MSU's currency risk exposures. - Why did MSU change from a policy of pricing its summer study abroad programs just prior to departure to a policy that priced the programs in the previous September? - How much higher or lower might student participation be given the new pricing policy? What might happen to MSU's study abroad budget if participation rates are lower - or higher - than expected? 3. How variable might the value of the euro be over the next 9 months? - Calculate the volatility or standard deviation of monthly returns (1) based on the data in Appendix B - Translate this to an estimate of 9-month volatility based on the relation T = (T)1 - What is the probability of the euro increasing by more than 10% during the next nine months? 4. Exhibit 5 presents a payoff profile of MSU's euro exposure, a forward euro hedge of that exposure, and the net position. Exhibit 6 presents the euro exposure and a 100% call option hedge. For each of the following euro positions, construct a graph showing the dollar-per-euro value of MSU's euro exposure (Vt$/) on the yaxis against the spot rate of exchange (St$/) on the x-axis. That is, plot the value of MSU's euro obligation at different levels of the spot rate is St/$, where the units on each axis are dollars per euro of exposure. - A partial forward hedge that covers 50% of the euro exposure - A partial option hedge (exercise price = $1.30/; premium = $0.0381/) that covers 50% of the euro exposure - A combination of a forward and an option hedge with each position covering 50% of the euro exposure - Suppose you paid for the cost of a long euro call option by selling a euro put with an exercise price of $1.30/ at an option premium of $0.0381/. Draw a payoff profile for this position. What does this position resemble? - Brett is not inclined to use currency futures because they would require the approval of MSU's Board of Trustees. If he were to consider futures hedges, on what basis should he compare the costs and benefits of a forward hedge to the costs and benefits of a futures hedge? - Can Brett compare the direct costs of a forward hedge to those of an option hedge? 5. Which of these hedges in question 4 best accomplishes the objective of your proposed hedging policy? 6. Suppose you expected the dollar to appreciate in value by 10% against the euro during the next 9 months. Given your proposed hedging policy, would you still hedge 100% of MSU's anticipated euro expenses? If not, how much would you hedge? 7. How you would implement the FX hedging program at MSU. In particular, what controls would you impose so that the Office of Study Abroad does not make a silly-but-possibly-catastrophic mistake in implementing its currency risk management program? 10 Managing exposures to currency risk at Michigan State University Appendix A - Memo to MSU study abroad program leaders (abridged) June 11, 2010 From: Brett Berquist To: MSU study abroad program leaders Re: Revising your program pricing This note outlines a new process for revising your program price for the next recruitment cycle. All program fees are to be set by September 1 so that students have full information at the start of recruitment efforts at the September 30 Study Abroad Fair. Final approval by the college remains a requirement. Dear colleague, Thanks to you MSU offers what may be the country's largest catalog of education abroad programs with 275 programs on all continents. What a treasure of opportunity available to our students through your tireless efforts and dedication. Families have noticed. A 2009 survey of admitted freshmen showed that 'study abroad opportunities' tops the list of MSU characteristics most often rated as 'excellent/very good' (MSU Office of Admissions, 2009). However, this translates into reality for just 1 in 3 of our students, for a variety of reasons. No one knows better than you how much the economy in Michigan has had an effect on the difficult choices our students face as they weigh the life-changing experience your program offers them against the limits of their family's financial support. My heart went out to the parents of students who did not receive a scholarship from OSA this year as I read their stories of dedication in the face of economic or personal hardship. Their messages hit close to home as I thought of my own daughter who will be enrolling at MSU this fall. Recently 1 in 4 students applying to study abroad have ultimately withdrawn, the majority of them citing financial reasons. There's not much you or I can do about the state of Michigan's economy. However, we can change the timing of the financial information we provide to students, which is cited as a reason for withdrawal equally as frequently as insufficient financial resources. Following the 2008 MSU study abroad task force report, best practice in international education, the demand of our students and families, and in collaboration with the deans' designees for study abroad, we have set the goal that study abroad programs will be fully priced before they are offered to students. Our program leaders show great fiscal responsibility and strive to keep costs as low as possible for students while offering the highest quality experience they can. The Office of Study Abroad works with you to establish a very detailed budget based on updated quotes, revised projections for enrollment, etc. The challenge with our current system is that revising 275 program budgets through 2 CPAs produces an inevitable bottleneck that results in program prices being set sometimes just a few weeks before departure. During this time students and their families pester you constantly for the final numbers so they can talk to financial aid and make a final decision. It's a difficult job for you to maintain students' interest while awaiting those final figures and then see as many as 25% of those you recruited withdraw. We have to take steps to change this timing. Most offices around the country revise pricing based on estimates before they launch the recruitment cycle in the fall. Granted, most offices don't have as broad a catalog or the volume that MSU handles. But they also don't have the incredible network of support that MSU has built over many years. With this support, we are moving from an accounting based budget finalized only after all quotes are received, to a proactive price revision based on analysis of past trends and reasonable projections. Your program coordinator will analyze past trends for your program, e.g. enrollment, program fee, exchange rates, etc. and e-mail you a revised pricing proposal. We've taken steps to make the template more user-friendly. It also includes more information on course assignments, itinerary planning, etc. If the price revision looks reasonable and you can live within that budget, you will only need to respond to the text revisions requested by the communications team in order to be ready for the 9/30 fair. If, however, you anticipate some major changes to your program next year, please let your coordinator know before the deadline indicated in the e-mail (usually 2 weeks) and set up a meeting in person or via skype to work out the revisions. The timing of this is tied to our production schedule for 275 programs for the catalog launch event on September 30. Consequently, we have a detailed production plan to send these proposals in waves based on your program's return date this summer. In order to fully support your recruitment efforts, price revisions must be completed by September 1. 11 Managing exposures to currency risk at Michigan State University I realize the timing of informing you of this shift would have been better when you were still on campus in the spring. As you can imagine, this decision involved much discussion with the deans' designees for study abroad as well as other offices and was not finalized until recently. Calling for improvements in timing of information is easy. Planning the most reasonable way to get there is less so. We are encouraged by the collaborative nature of all the conversations we've had on this. At the end of my first academic year at MSU, I'm still constantly amazed by the depth of support that international education has on this campus. You are the front line. Without your efforts, there would be no study abroad at MSU. But know that the support for your efforts runs deep all across campus. It may not feel like it at times as you interact with what you may see as a large bureaucracy. I suppose that given the size of our activities, inevitably we are. But our goal is to improve our service to better support your efforts. We are confident that these steps to have pricing precede recruitment will ultimately make your life easier and increase the retention of the students you recruit to your program. In this vein, I'm pleased to announce that because of these changes the Office of Financial Aid will now begin processing award packages for applicants to summer 2011 programs in December 2010. This will greatly increase the level of information MSU provides to interested students. Please feel free to contact me, your program coordinator, or your college's dean's designee for study abroad with particular questions. We appreciate your patience as we work hard to improve our service to you and your students. Thanking you for all that you do for students, Brett Berquist, Executive Director, Office of Study Abroad Michigan State University, East Lansing, Michigan 48824 12 Managing exposures to currency risk at Michigan State University Appendix B End-of-month spot rates (mid) from oanda.com as foreign currency f per U.S. dollar (Stf/$) FX rate 1998 Dec 1999 Jan 1999 Feb 1999 Mar 1999 Apr 1999 May 1999 Jun 1999 Jul 1999 Aug 1999 Sep 1999 Oct 1999 Nov 1999 Dec 2000 Jan 2000 Feb 2000 Mar 2000 Apr 2000 May 2000 Jun 2000 Jul 2000 Aug 2000 Sep 2000 Oct 2000 Nov 2000 Dec 2001 Jan 2001 Feb 2001 Mar 2001 Apr 2001 May 2001 Jun 2001 Jul 2001 Aug 2001 Sep 2001 Oct 2001 Nov 2001 Dec 2002 Jan 2002 Feb 2002 Mar 2002 Apr 2002 May 2002 Jun 2002 Jul 2002 Aug 2002 Sep 2002 Oct 2002 Nov 2002 Dec 2003 Jan 2003 Feb 2003 Mar 2003 Apr 2003 May 2003 Jun 2003 Jul 2003 Aug 2003 Sep 2003 Oct 2003 Nov 2003 Dec /$ 0.8568 0.8747 0.9058 0.9314 0.9439 0.9561 0.9683 0.9336 0.9485 0.9387 0.9474 0.9914 0.9956 1.0233 1.0288 1.0404 1.0966 1.0756 1.0508 1.0823 1.1193 1.1372 1.1889 1.1659 1.0618 1.0793 1.0896 1.1377 1.1239 1.1665 1.1774 1.1435 1.0911 1.0993 1.1054 1.1258 1.1288 1.1609 1.1551 1.1493 1.1065 1.0670 1.0085 1.0169 1.0181 1.0192 1.0160 1.0056 0.9540 0.9247 0.9296 0.9262 0.9022 0.8489 0.8744 0.8816 0.9105 0.8624 0.8595 0.8342 0.7966 /$ 0.6028 0.6071 0.6251 0.6202 0.6205 0.6239 0.6348 0.6167 0.6237 0.6075 0.6207 0.6254 0.6184 0.6175 0.6269 0.6264 0.6444 0.6686 0.6585 0.6654 0.6851 0.6834 0.6891 0.7028 0.6698 0.6837 0.6930 0.7060 0.6947 0.7008 0.7068 0.7010 0.6862 0.6781 0.6889 0.7006 0.6890 0.7070 0.7039 0.7014 0.6853 0.6824 0.6525 0.6353 0.6449 0.6405 0.6420 0.6424 0.6234 0.6047 0.6329 0.6352 0.6272 0.6113 0.6063 0.6188 0.6340 0.6000 0.5896 0.5807 0.5624 A$/$ 1.6303 1.5834 1.6149 1.5864 1.5158 1.5406 1.5119 1.5352 1.5679 1.5324 1.5657 1.5732 1.5362 1.5692 1.6279 1.6321 1.7132 1.7346 1.6606 1.6967 1.7359 1.8340 1.9104 1.9194 1.7872 1.8243 1.9017 2.0599 1.9653 1.9497 1.9597 1.9782 1.8803 2.0274 1.9835 1.9313 1.9556 1.9735 1.9401 1.8739 1.8555 1.7726 1.7743 1.8394 1.8163 1.8404 1.8075 1.7837 1.7705 1.6978 1.6524 1.6645 1.6069 1.5319 1.4994 1.5319 1.5445 1.4762 1.4202 1.3804 1.3347 /$ 113.65 115.90 119.23 119.15 119.58 121.50 120.92 114.56 109.64 105.94 104.12 102.06 102.18 107.07 109.47 105.49 108.15 107.88 105.20 109.55 106.45 107.57 108.96 111.18 114.43 115.87 116.13 126.29 124.07 120.36 124.72 125.07 119.45 119.54 121.97 123.80 131.13 132.86 134.36 132.64 128.05 123.41 119.55 120.20 118.33 122.59 122.92 122.55 118.53 119.06 117.56 119.84 119.75 119.32 119.62 120.28 116.93 110.79 108.74 109.65 107.07 FX rate 2004 Jan 2004 Feb 2004 Mar 2004 Apr 2004 May 2004 Jun 2004 Jul 2004 Aug 2004 Sep 2004 Oct 2004 Nov 2004 Dec 2005 Jan 2005 Feb 2005 Mar 2005 Apr 2005 May 2005 Jun 2005 Jul 2005 Aug 2005 Sep 2005 Oct 2005 Nov 2005 Dec 2006 Jan 2006 Feb 2006 Mar 2006 Apr 2006 May 2006 Jun 2006 Jul 2006 Aug 2006 Sep 2006 Oct 2006 Nov 2006 Dec 2007 Jan 2007 Feb 2007 Mar 2007 Apr 2007 May 2007 Jun 2007 Jul 2007 Aug 2007 Sep 2007 Oct 2007 Nov 2007 Dec 2008 Jan 2008 Feb 2008 Mar 2008 Apr 2008 May 2008 Jun 2008 Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec /$ /$ A$/$ /$ 0.8022 0.8005 0.8214 0.8347 0.8169 0.8276 0.8317 0.8298 0.8112 0.7817 0.7535 0.7330 0.7673 0.7552 0.7743 0.7771 0.8018 0.8289 0.8246 0.8181 0.8302 0.8292 0.8532 0.8444 0.8269 0.8434 0.8282 0.7916 0.7797 0.7969 0.7837 0.7795 0.7883 0.7859 0.7590 0.7577 0.7716 0.7573 0.7500 0.7325 0.7442 0.7422 0.7323 0.7328 0.7010 0.6940 0.6761 0.6792 0.6765 0.6611 0.6331 0.6407 0.6442 0.6332 0.6418 0.6815 0.6922 0.7661 0.7879 0.7095 0.5505 0.5352 0.5477 0.5637 0.5452 0.5534 0.5491 0.5568 0.5558 0.5426 0.5281 0.5191 0.5299 0.5212 0.5323 0.5243 0.5485 0.5542 0.5688 0.5598 0.5674 0.5636 0.5839 0.5812 0.5659 0.5742 0.5749 0.5478 0.5342 0.5507 0.5367 0.5261 0.5341 0.5266 0.5127 0.5106 0.5095 0.5092 0.5095 0.5006 0.5055 0.4991 0.4941 0.4966 0.4885 0.4847 0.4830 0.5008 0.5026 0.5040 0.5014 0.5046 0.5061 0.5013 0.5050 0.5492 0.5503 0.6070 0.6505 0.6908 1.3141 1.2921 1.3272 1.3843 1.3995 1.4492 1.4246 1.4302 1.3953 1.3297 1.2755 1.2823 1.2927 1.2715 1.2987 1.2805 1.3149 1.3127 1.3214 1.3369 1.3156 1.3329 1.3611 1.3700 1.3338 1.3543 1.4066 1.3165 1.3134 1.3699 1.3032 1.3100 1.3392 1.3005 1.2767 1.2677 1.2947 1.2610 1.2378 1.2049 1.2203 1.1782 1.1750 1.2233 1.1263 1.0875 1.1317 1.1412 1.1253 1.0605 1.0902 1.0696 1.0467 1.0406 1.0554 1.1656 1.2182 1.4760 1.5274 1.4483 105.94 109.18 105.63 109.79 110.35 108.35 111.20 109.92 110.91 105.78 102.85 103.07 103.49 105.23 107.54 104.87 107.98 110.56 112.48 111.28 113.00 115.67 119.69 117.85 117.44 116.29 117.58 113.83 112.16 116.31 114.65 116.93 117.92 117.44 116.06 119.06 121.76 119.77 117.92 119.62 121.58 123.31 118.51 115.72 114.86 114.66 109.97 112.30 106.97 106.17 99.24 104.04 105.47 106.12 108.05 108.81 105.88 98.21 95.53 90.37 13 FX rate 2009 Jan 2009 Feb 2009 Mar 2009 Apr 2009 May 2009 Jun 2009 Jul 2009 Aug 2009 Sep 2009 Oct 2009 Nov 2009 Dec 2010 Jan 2010 Feb 2010 Mar 2010 Apr 2010 May 2010 Jun 2010 Jul 2010 Aug 2010 Sep 2010 Oct 2010 Nov 2010 Dec 2011 Jan 2011 Feb 2011 Mar 2011 Apr 2011 May 2011 Jun 2011 Jul 2011 Aug 2011 Sep 2011 Oct 2011 Nov 2011 Dec 2012 Jan 2012 Feb 2012 Mar 2012 Apr 2012 May 2012 Jun 2012 Jul 2012 Aug 2012 Sep 2012 Oct 2012 Nov 2012 Dec 2013 Jan 2013 Feb 2013 Mar 2013 Apr 2013 May 2013 Jun 2013 Jul /$ 0.7769 0.7877 0.7572 0.7568 0.7068 0.7119 0.7113 0.6991 0.6854 0.6755 0.6670 0.6977 0.7213 0.7338 0.7433 0.7555 0.8149 0.8192 0.7668 0.7873 0.7348 0.7170 0.7581 0.7546 0.7349 0.7271 0.7093 0.6739 0.7002 0.6949 0.6947 0.6912 0.7355 0.7069 0.7499 0.7723 0.7604 0.7446 0.7497 0.7546 0.8038 0.7951 0.8148 0.7980 0.7777 0.7731 0.7713 0.7566 0.7394 0.7643 0.7800 0.7649 0.7699 0.7685 0.7539 /$ A$/$ 0.6990 0.7013 0.7037 0.6795 0.6177 0.6054 0.6080 0.6147 0.6282 0.6052 0.6057 0.6279 0.6255 0.6563 0.6636 0.6556 0.6922 0.6636 0.6393 0.6446 0.6327 0.6235 0.6417 0.6465 0.6308 0.6205 0.6238 0.6001 0.6071 0.6243 0.6088 0.6117 0.6400 0.6201 0.6428 0.6471 0.6371 0.6310 0.6254 0.6149 0.6420 0.6404 0.6366 0.6320 0.6186 0.6229 0.6241 0.6188 0.6343 0.6610 0.6575 0.6448 0.6593 0.6572 0.6534 /$ 1.5554 89.67 1.5551 97.76 1.4634 97.28 1.3964 96.87 1.2485 95.34 1.2428 95.54 1.2165 95.25 1.1890 93.57 1.1458 89.97 1.0980 90.95 1.1024 86.61 1.1198 92.23 1.1316 90.27 1.1168 88.94 1.0877 92.68 1.0787 94.05 1.1803 91.05 1.1675 88.65 1.1099 86.40 1.1158 84.83 1.0309 83.66 1.0165 80.38 1.0378 84.15 0.9841 81.55 1.0063 82.11 0.9829 81.68 0.9700 82.86 0.9147 81.41 0.9352 80.86 0.9437 80.98 0.9094 76.76 0.9376 76.78 1.0212 76.62 0.9345 75.79 1.0032 77.95 0.9828 77.41 0.9450 76.60 0.9291 80.48 0.9628 82.28 0.9551 80.31 1.0233 79.25 0.9842 79.53 0.9543 78.30 0.9687 78.63 0.9635 77.92 0.9655 79.64 0.9565 82.10 0.9641 85.89 0.9573 91.04 0.9792 91.82 0.9594 94.16 0.9685 97.83 1.0358 101.01 1.0934 99.10 1.0988 98.08