In this paper I intend to introduce the relevant options available to a multi-national enterprise when dealing with foreign exchange risk. I am going to use Toyota Motor Corporation throughout as an example. Toyota is the world's third largest automaker. It was established in Japan on August 28th 1937 and apart from its 12 plants in Japan, has 54 manufacturing companies in 27 countries, employs 246,700 people and markets vehicles in more than 160 countries. (Toyota website, 2004) Toyota is exposed to the fluctuation in foreign currency exchange as it operates mainly in America, Europe and Britain. It is therefore affected by the fluctuation in the value of the US dollar, the Euro and to a lesser extent the British pound. Toyota's consolidated financial statements, which are presented in the Japanese yen, are affected by the foreign exchange fluctuation, as all the amounts in the various countries' currencies have to be translated into yen.
There is no one clear definition of foreign exchange risk. It takes into consideration the level of exposure that a multi-national enterprise has on foreign markets. When we speak of foreign exchange exposure, we are referring to the risk that future changes in a country's exchange rate will have positive or negative effects on the firm.
The value of the Japanese yen has fallen generally for the past three years against the dollar and the Euro though there had been periods of fluctuations. Changes in foreign exchange rates affect a multi-national enterprise's revenue, gross margins, operating costs, operating income, net income and retained earnings. Toyota's cost and liabilities are affected by transaction exposure which relates primarily to sales proceed from Toyota's non-domestic sales produced in Japan. It is also affected to a lesser extent sales proceed from Toyota's Europe sales produced in UK.
The first step in management of corporate foreign exchange risk is to acknowledge that such risk does exist and that managing it is in the interest of the firm and its shareholders. The next step, however, is much more difficult: the identification of the nature and magnitude of foreign exchange exposure. In other words, identifying what is at risk, and in what way.
The task of gauging the impact of exchange rate changes on an enterprise begins with measuring its exposure, that is, the amount, or value, at risk. This issue has been distorted by the fact that financial results for an enterprise tend to be compiled by methods based on the principles of accrual accounting. (Pilbeam) Unfortunately, this approach yields data that frequently differ from those relevant for business decision-making, namely future cash flows and their associated risk profiles. As a result, considerable efforts are exhausted to reconcile the differences between the point-in-time effects of exchange rate changes on an enterprise in terms of accounting data, referred to as translation exposure, and the ongoing cash flow effects which are referred to as economic exposure. Both concepts have their grounding in the fundamental concept of transactions exposure.
Trading or "dealing" in currencies consists of two parts, the spot market, where payment is made right away (in practice this usually means two business days later), and the forward market. The rate in the forward market is a price for foreign currency set at the time the transaction is agreed but with the actual exchange, or delivery, taking place at a specified time in the future. While the amount of the transaction, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a forward contract.
When there is a depreciation or appreciation of the currencies in relation to the yen, Toyota will have to choose whether or not to alter the price to reflect the change in the exchange rate. This decision will depend on the price elasticity of demand for cars among other factors. Toyota manages these risks by using forward contracts, money market hedging and option market hedging.
Forward contracts are the most common means of hedging transactions in foreign currencies. They are used to limit exposure to losses. One problem with forward contracts, however, is that they require future performance; and occasionally one party is unable to perform on the contract. When this happens, the hedge disappears, sometimes at great cost to the hedger.
Toyota enters into forward contracts and purchases currency options, which are principally expressed in euros and dollars, to hedge certain portions of forecasted cash flows denominated in foreign currencies. Additionally, they enter into forward contracts to offset the earnings impact relating to exchange rate fluctuations on certain monetary assets and liabilities. The company enters into forward exchange contracts as a form of hedging net investments in international operations. This reduces foreign exchange risk and transaction costs in those settlements by handling receipts in the foreign currencies in which they are denominated. (Hill)
For example, Toyota buys supplies from Peugeot in France and is hence exposed to the Euro exchange rate. It also manufactures engines in Japan for BMW. These inflows and outflows with Europe expose Toyota to foreign exchange risks. Cars produced in Japan and other production sites are shipped to Europe and America. Toyota then has to make the decision as to which currency to price the cars. If the cars are priced in yen in order to avoid foreign exchange risk, Toyota will not be competitive in those markets, as it will have shifted the risk to its customers. If the price is in the domestic currencies, Toyota will be exposed to foreign exchange risk.
There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward contract provides. For example a computer manufacturer in California may have sales priced in U.S. dollars as well as in UK pounds in Europe. Depending on the relative strength of the two currencies, revenues may be displayed in either pounds or dollars. In such a situation the use of forward or futures would be inappropriate as there is very little purpose in hedging something you might not have. What is called for is a foreign exchange option. "A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, but is not required to do so." (Giddy) For the right to buy or sell, the holder pays a price called the option premium. The option seller receives the premium and is obliged to make delivery at the agreed-upon price if the buyer exercises his option.
Toyota is exposed to translation risk when the results of subsidiaries are translated into yen. The value in yen may not reflect the true value of the subsidiary, as it will also depend on the exchange rate between the two countries at the time of the translation. This can distort significantly when results of different periods are being compared and among various geographical markets. The value of the yen against the Euro and the dollar fell generally for the past four years. This fall of the yen has made Toyota alleged profit when it is translated into yen though in actual fact it may not have been this way.
The most obvious source or determinant of economic currency exposure comes from firms having revenues or costs denominated in foreign currencies. These transaction effects are relatively easy to identify and manage. In addition, firms that also have foreign-based operations will have translation exposures that arise from consolidation. At the same time, there are also a number of indirect effects, which can be just as important and apply both to firms engaged in international business and to domestic firms, but which are substantially more difficult to recognise. This indirect economic currency exposure arises from unexpected movements in foreign exchange rates changing the competitive situation of the firm and which affect the firm's future cash flows (and hence value). (Buckley)
Exchange rates and inflation rates are linked to each another through a classical relationship. This is defined as the purchasing power parity theory. This theory can be stated in different ways, but the most common representation links the changes in exchange rates to those in relative price indices in two countries. The relationship is derived from the basic idea that, in the absence of trade restrictions, changes in the exchange rate will mirror changes in the relative price levels in the two countries. At the same time, under conditions of free trade, prices of similar commodities cannot differ between two countries, because arbitragers will take advantage of such situations until price differences are eliminated. This 'law of one price' leads to the idea that what is true of one commodity should be true of the economy as a whole - the price level in two countries should be linked through the exchange rate - and hence to the notion that exchange rate changes are tied to inflation rate differences. "If there is higher inflation in one country in relation to others, prices of goods and services will increase in that country and exchange rates will have to change accordingly in response to inflation differentials." (Pilbeam)
The link between interest rates and exchange rates is explained by using the International Fisher Effect (IFE). This states that the interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions. In practical terms the IFE implies that while an investor in a low-interest country can convert his funds into the currency of the high-interest country and get paid a higher rate, his gain (the interest rate differential) will be offset by his expected loss because of foreign exchange rate changes.
Firms can minimise their foreign exchange exposure through leading and lagging payables and receivables - that is, collecting and paying early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy is, quite simply, the reverse of this. Leading and lagging involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries. (Hill)
Another possibility open to multi-national enterprises is netting. The basis of this is that, within a closed group of related companies, total payables will always equal total receivables. (Giddy) Netting is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries. In the case of Toyota, instead of paying monies owed to and by each subsidiary, together they can, in effect, clear each other's debt and thereby not deal in the foreign exchange market. As there is no dealing, the foreign exchange conversion fees and funds transfer fees have been at least minimised if not avoided completely. The settlements are resolved quickly through Toyota's in-house foreign exchange centre so this reduces the company's overall exposure.
The firm may choose to engage in a process called natural hedging. This is used to manage an anticipated exposure to a particular currency by acquiring a debt denominated in that currency. (Pilbeam) Hence, if a firm has a long-term inflow in one currency, they can acquire an outflow in the form of a loan in the same currency. When the loan repayment is required, they can use the inflow to service the debt. For example, Toyota has main markets in America and Europe; it can take out loans in Dollars and Euros and use the earnings from its operations to pay back the loan. This will mean that exchange rates need not be taken into consideration as fluctuations will not alter the amount repayable.
One of the lesser-used options available is what is called back-to-back loans. This occurs when two firms arrange to borrow money in each other's currency so as to avoid the risk that is related with exchange rate fluctuation. For example, Toyota could enter into an agreement with an American company that has a subsidiary in Japan. If Toyota were to lend Yen to the Japanese office of the American company, in return, the American company would lend Dollars to Toyota's American plant. This clearly will dramatically reduce the risk that Toyota would have come up against if it had had to exchange Yen to Dollars. The obvious advantage with this form of money lending is, as with netting, there are minimal fees applicable and that the only element of risk is whether the American company will comply. This option is lesser used as very few firms will be willing to engage in such a contract.
In summation, there are many different strategies available to a multi-national enterprise in order to reduce foreign exchange risk. A firm will frequently be monitoring the fluctuations of exchange rates to try to minimise any losses that may come about. If they do enter into a contract, they have to be sure that holder will be able to perform their side of the deal upon completion. There has to be a central element of control over all of the proceedings so as to ensure continuity across the company.
Appleyard, D,R. & Field, A,J. (2001) International Economics, New York, McGraw-Hill Companies
Buckley, P. & Casson, M. (1992) Multinational Enterprises in the World Economy,
Giddy, I,H. (2001) The Management of Foreign Exchange Risk, New York, NYU Press
Hill, C,W,L. (2000) International Business: Competiting in the Global Marketplace, New York, McGraw-Hill Companies
Pilbeam, K. (1992) International Finance, Basingstoke, Macmillan Education