Boston Exchange (BE) is a US-based company that sends more than 50,000 students each year on academic and cultural exchange programs worldwide. Two of the group's main divisions focused on Americans traveling abroad: The College division organizes 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 are for academic credit, with most participants traveling to Europe. The High School Travel division organizes chaperoned educational travel for about 20,000 high school students and teachers annually. At BE, the managers use currency hedging to help them manage three types of risk. First is the bottom-line risk, or the risk that an adverse change in exchange rates could increase the cost base.

Second, the volume risk, since foreign currency is bought based on projected sales volumes, which would differ from final sales volumes. Third, competitive pricing risk, since no matter how currencies fluctuated, the BE price guarantee means it could not transfer rate changes into price increases. To help inform its hedging decisions, the managers desire an analytical currency hedging policy. In essence, the policy would address two key questions. First, what percentage of the expected requirements should BE cover? Second, within the cover, what should be the proportion of futures contracts versus options? In the end, the two unknowns—final sales volume and final dollar exchange rate—determined what economic impact the hedging activities would have on the company. The managers recognize that a comprehensive model that covered different scenarios could be very useful in identifying the consequences of different hedging strategies. Such a model, though, would also generate a wide range of outcomes that could prove overwhelming. Therefore, the managers should start by focusing on the expected final sales volume of 25,000 and to analyze three simple hedging strategies with 100% coverage (i.e., no hedging, 100% futures, and 100% options) and three possible dollar- euro exchange rate levels (i.e., $1 to 1 euro, $1.25, and $1.50). The managers calculate that BE's average cost per participant is €1000. At the current exchange rate of 1.25 USD/EUR, dollar costs per participant would be $1250, or a total of $31.25 million for the projected sales volume of 25,000. The managers define this level of dollar costs as the 'zero impact' scenario. Regarding hedging costs, the Do-Nothing strategy and the futures hedge both incur no additional expense. For the option strategy, BE would have to pay an option premium of 5% of the USD notional value. How should BE manage its risk exposure?  You should explain all of your estimates.

 

a) What would happen with a 100% hedge with futures (0% hedge with options)? What would happen with a 75% hedge with futures (25% hedge with options)? What would happen with a 50% hedge with futures (50% hedge with options)? What would happen with a 25% hedge with futures (75% hedge with options)? What would happen with a 0% hedge with futures (100% hedge with options)? Use the forecast final sales volume of 25,000 and analyze the possible outcomes relative to the 'zero impact' scenario. Explain fully and support with analysis.

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