AIFS’ business of sending students abroad and the timing difference between when the prices were set and when payment was received created transaction exposure. Guaranteeing that prices of the trips would not change prior to the release of the next catalog was a major table stake of the company’s business, and very important to maintaining a loyal customer base. Given this, movements in the cost basis caused by fluctuations in exchange rates could not be passed onto customers. When combined with the fact that there was a relatively long lead time between when prices were locked in and when the payment from students was received (over a year in the college student program) resulted in a significant amount of uncertainty regarding the company’s primary operating cost. The potential variance in the annual volume of students enrolled in the company’s programs also created issues with currency exposure. Hedging based on projected sales totals is difficult, especially when certain events that can materially impact volumes are well beyond the company’s control.
If no hedging was done, the company would be fully exposed to the movements in exchange rates after each price was set/catalog was issued. The magnitude and direction of the movements from when the price was locked in would determine the gain or loss on each individual trip that was booked. This would cause the company’s cash flows to be quite volatile, and this uncertainty would create a litany of problems for the company. Managing working capital and liquidity, obtaining financing, and undertaking capital budgeting would be exceedingly difficult without some level of hedging. A 100% hedge with forward contracts removes any of the volatility associated with the transaction, assuming that exactly 25,000 students purchase a trip package. This is because the forward contract is a commitment, rather than an option,