Harvard Case - Alumni Action Foundation: Currency Hedging Strategy
"Alumni Action Foundation: Currency Hedging Strategy" Harvard business case study is written by Walid Busaba, Zeigham Khokher, Ken Mark. It deals with the challenges in the field of Finance. The case study is 14 page(s) long and it was first published on : Oct 27, 2010
At Fern Fort University, we recommend that the Alumni Action Foundation (AAF) implement a comprehensive currency hedging strategy to mitigate the risk of foreign exchange fluctuations on its investment portfolio. This strategy should prioritize a balanced approach, combining forward contracts for short-term exposures and options contracts for longer-term, more volatile exposures. This will allow the AAF to maintain its investment returns while minimizing the impact of currency fluctuations on its overall financial performance.
2. Background
The Alumni Action Foundation (AAF) is a non-profit organization dedicated to supporting Fern Fort University. The AAF manages a substantial investment portfolio, a portion of which is invested in foreign securities. The foundation is concerned about the potential impact of currency fluctuations on its investment returns, particularly given the recent volatility in foreign exchange markets.
The main protagonists of the case study are:
- The AAF Board of Directors: Responsible for overseeing the foundation's investments and ensuring the long-term financial sustainability of the organization.
- The AAF Investment Committee: Responsible for developing and implementing the foundation's investment strategy.
- The AAF Treasurer: Responsible for managing the foundation's finances and ensuring compliance with relevant regulations.
3. Analysis of the Case Study
This case study presents a classic example of the challenges faced by investors with international exposure. The AAF needs to balance the potential for higher returns from foreign investments with the risk of currency fluctuations. To analyze the situation, we can utilize the following frameworks:
- Financial Analysis: This framework helps us assess the AAF's current financial position, including its investment portfolio, cash flow, and risk tolerance. We can use financial statements, ratio analysis, and valuation methods to understand the AAF's financial health and identify areas for improvement.
- Risk Management: This framework helps us identify and assess the various risks associated with the AAF's investment portfolio, including currency risk, market risk, and credit risk. We can use risk assessment techniques and financial modeling to quantify these risks and develop strategies to mitigate them.
- Investment Management: This framework helps us develop a comprehensive investment strategy for the AAF, taking into account its risk tolerance, investment objectives, and time horizon. We can use portfolio management techniques, asset allocation strategies, and capital budgeting tools to optimize the AAF's investment portfolio.
4. Recommendations
The AAF should implement the following currency hedging strategy:
- Short-Term Hedging: For short-term investments, the AAF should use forward contracts to lock in exchange rates for specific periods. This will provide certainty about future cash flows and minimize the risk of currency fluctuations.
- Long-Term Hedging: For longer-term investments, the AAF should use options contracts, specifically put options, to protect against potential declines in foreign currencies. This will provide downside protection while still allowing the AAF to participate in potential upside gains.
- Dynamic Hedging: The AAF should consider a dynamic hedging approach, adjusting its hedging strategy based on changes in market conditions and currency forecasts. This will allow the AAF to optimize its hedging strategy and minimize unnecessary hedging costs.
- Diversification: The AAF should diversify its investment portfolio across multiple currencies and asset classes to reduce overall risk. This will help to mitigate the impact of currency fluctuations on the overall portfolio.
5. Basis of Recommendations
This recommendation considers the following:
- Core competencies and consistency with mission: The AAF's mission is to support Fern Fort University. By protecting its investment portfolio from currency fluctuations, the AAF can ensure the long-term financial sustainability of the university.
- External customers and internal clients: The AAF's external customers are the students and faculty of Fern Fort University. By maximizing its investment returns, the AAF can provide more resources to support the university's educational mission.
- Competitors: The AAF does not have direct competitors in the sense of other foundations competing for the same investments. However, it does compete with other investment vehicles for the same capital. By implementing a sound currency hedging strategy, the AAF can improve its overall investment performance and remain competitive.
- Attractiveness ' quantitative measures: The AAF's hedging strategy should be evaluated based on its potential to reduce risk and enhance returns. This can be assessed using metrics such as risk-adjusted return, Sharpe ratio, and drawdown.
- Assumptions: The AAF's hedging strategy relies on the assumption that currency markets will continue to be volatile and that the AAF can effectively manage its hedging activities.
6. Conclusion
By implementing a comprehensive currency hedging strategy, the Alumni Action Foundation can mitigate the risk of foreign exchange fluctuations on its investment portfolio and ensure the long-term financial sustainability of Fern Fort University. This strategy should prioritize a balanced approach, combining forward contracts for short-term exposures and options contracts for longer-term, more volatile exposures.
7. Discussion
Other alternatives not selected include:
- No hedging: This option would expose the AAF to significant currency risk, potentially leading to losses on its investments.
- Full hedging: This option would eliminate all currency risk but could also limit potential upside gains.
Key risks and assumptions of the recommended strategy:
- Market risk: The AAF's hedging strategy relies on the assumption that currency markets will continue to be volatile. If markets become less volatile, the AAF may incur unnecessary hedging costs.
- Counterparty risk: The AAF's hedging strategy involves entering into contracts with financial institutions. There is a risk that these institutions may default on their obligations, leading to losses for the AAF.
- Operational risk: The AAF needs to ensure that it has the necessary expertise and resources to effectively manage its hedging activities.
8. Next Steps
The AAF should take the following steps to implement its currency hedging strategy:
- Develop a detailed hedging policy: This policy should outline the AAF's hedging objectives, risk tolerance, and specific hedging strategies.
- Select appropriate hedging instruments: The AAF should carefully evaluate the different hedging instruments available and select those that best meet its needs.
- Establish a monitoring and reporting system: The AAF should regularly monitor its hedging activities and report on their effectiveness to the Board of Directors.
- Train staff: The AAF should provide its staff with the necessary training to effectively manage its hedging activities.
By taking these steps, the AAF can effectively mitigate the risk of currency fluctuations and ensure the long-term financial sustainability of Fern Fort University.
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Case Description
The executive director of an independent charitable foundation is thinking about whether to hedge his foundation's U.S. dollar exposure given the large swings in the Canadian dollar-U.S. dollar exchange rate. For the past four years, the weakening U.S. dollar has contributed to underperformance in the foundation's portfolio relative to its peers.
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