Foreign exchange risk Essay

Toyota Motor Corporation is the worlds third largest auto micturater. It was formal in Japan on 28 August 1937. Apart from its 12 plants in Japan, Toyota has 54 manufacturing companies in 27 countries, employs 246700 people and commercialises vehicles in more than maven hundred sixty countries. Its capital as at March 2002 was 397 one million million million fade.Toyota is lurkd to the fluctuation in distant silver metamorphose as it ope range primary(prenominal)ly in the States, Continental atomic number 63 and Britain. It is and so affected by the fluctuation in the lever of the US sawhorse, the Euro and to a lesser extent the British pound. Toyotas consolidated pecuniary statements, which are presented in the Japanese yen, are affected by the contrasted supercede fluctuation, as all the marrows in the various countries currencies stir to be translated into yen. Toyotas primary grocerys based on unit sales for vehicles for financial year ended March 31 2002 we re Japan (40%), North America (32%) and europium (13%). Toyota is listed on the London, New York and Tokyo stock supplants.In the normal course of doing line of work, Toyota employs derivatives financial instruments, including forward gets and world(prenominal) funds options to manage its motion picture to fluctuation in unusual property exchange rates. Toyota does non use derivatives for speculation and trading. (http//www.toyota.co.jp/en/ir.html accessed on 14th November 2002) The profitability of Toyotas operations is affected by many factors including the changes in the value of the Japanese yen against other currencies which Toyota does railway line. The financial year for Toyota is from 1 April to 31 March.IMPACT OF FOREIGN EXCHANGE RISK ON OPERATIONThe value of the Japanese yen has amounten generally for the past common chord years against the dollar and the Euro though there had been periods offluctuations. (http//pacific.commerce.ubc.ca/xr/data.html accessed o n 14th November 2002). Changes in unusual exchange rate affect Toyotas revenue, gross margins, operating costs, operating in add, gain income and retained earnings. Toyotas cost and liabilities are affected by transaction motion picture which relates primarily to sales proceed from Toyotas non domestic sales produced in Japan. It is similarly affected to a lesser extent sales proceed from Toyotas continental Europe sales produced in UK.Toyotas use of forward exchange rate contracts and currency options is to hedge foreign exchange venture associated with contend receivables denominated primarily in U.S. dollars. Toyota also engages in foreign currency settlements with domestic counter parties. The companionship enters into forward contracts and purchases currency options (principally euro and dollar) to hedge current portions of forecasted cash flows denominated in foreign currencies. Additionally, the Company enters into forward exchange contracts to offset the earnings imp act relating to exchange rate fluctuations on certain monetary assets and liabilities. The Company enters into forward exchange contracts as hedges of 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.Toyota depraves supplies from Peugeot in France and is therefore exposed to the Euro exchange rate. It also manufactures engines in Japan for BMW. These inflows and outflows as a result of dealing with these European companies expose Toyota to foreign exchange risks. Cars produced in Japan and other production sites are shipped to Europe and America, which are the major market for Toyota. Toyota has to make a decision as to which currency to harm the cars. If the cars are priced in yen in order to avoid foreign exchange risk, Toyota forget non be rivalrous in those markets, as it would start out shifted the risk to its customers. If the price is in the domestic currencies Toyota pull up stakes be exposed to foreign exchange risk. When there is a depreciation or appreciation of the currencies in relation to the yen, Toyota forget be torn between changing the price to contrive the change in the exchange rate.This decision exit depend on the price elasticity of holdfor cars among other factors. Toyota manages these risks by using forward contracts, money market hedging and option market hedging. Toyota also enters into currency borrowing to address a portion of its transaction risk. abroad exchange forward contracts are used to limit exposure to issuees, resulting from changes in foreign currency exchange rates on accounts receivable and transactions denominated in foreign currencies. Foreign exchange forward contracts, which are designated and forcefulnessive as hedges of currency, risk on existing assets and liabilities are included as an offset to foreign exchange gain or loss and recorded on the exist ing assets and liabilities. Foreign currency option is to reduce the risks that are likely to be incurred on account receivable and anticipated transactions denominated in foreign currencies. This has reduced, exactly non eliminated, the effects of foreign exchange fluctuation.The preparation of Toyotas consolidated financial statements is in conformity with accounting principles accepted in the United States of America. All assets and liabilities of foreign subsidiaries are translated into Japanese yen at the appropriate year end current rates and all income and expense accounts are translated at rates that estimate those prevailing at the time of the transaction. Toyota therefore uses the temporal method of transformation. The resulting translation adjustments are included as a component of accumulated income. Toyota is exposed to translation risk when the results of subsidiaries are translated into yen. The value in yen whitethorn not reflect the lawful value of the accesso ry, as it will also depend on the exchange rate between the two countries at the time of the translation.This bay window distort significantly when results of different periods are be compared and among various geographical markets. The yen has been stronger in fiscal year 2000 as against 1999. According to Toyotas Annual Reports, net revenue adjoind by 6.1% in 1999 and decrease by 0.4% in 2000. If the contrast in yen used for translation purposes are eliminated, net revenue would have increased by 5.9% in 1999 and increased by 11.2% in 2000 (http//www.toyota.co.jp/en/ir.html accessed on 14th November 2002). Thus, even though the consolidation figure showed a decrease in net revenue in 2000, it was mainly collectable to the strengthening of the yen in 2000, which made dollar values smaller after translation.The value of the yen against the Euro and the dollar fell generally for the past three years. The fall of the yen for the past three years has made Toyota reported profit wh en it is translated into yen though in actual fact it may not have been so. Toyotas net revenue for fiscal year 2002 showed a 9% increase over the previous year. This is because of the weakening yen and the translation effect. If the difference in yen value used for translation purposes is eliminated, Toyota showed only 2.8% increase. Net revenue increased by 15.5% in North America, 24.8% in Europe and 0.4% in Japan, for fiscal 2002 compared to 2001 after consolidation.If translation effect is eliminated, the net revenue in North America increases by only 2.2% and 12.9% in Europe (http//www.toyota.co.jp/en/ir.html accessed on 14th November 2002). There was a double digit devaluation of the yen to the dollar in the business year ended March 31 2002. Toyota gained 70 exciteion yen from favourable exchange rate. The US dollar rose to about 127 yen from about 123 yen a year ago. A strong dollar armed services the earning of Toyota by boosting the value of overseas revenue when conver ted into yen. However, translation effect is a reporting consideration and does not affect Toyotas underlying operation. Toyota does not hedge against translation risk.Toyota manages its operating exposure by diversifying its operation and financing. It has localised much of its production by constructing production units in most of the countries in which it operates. local operation allows Toyota to purchase most of its supplies and resources used in the production process in currencies that matches the currencies of local revenue with local expenses. Toyota has asked its UK suppliers to settle all bills using Europes single currency, the euro (http//news.bbc.co.uk/1/hi/business/873840.stm accessed on 16th November 2002). This reduces its exposure to changes in the value of the pound.Toyota has diversify its finance base by being able to raise funds in more than one place and thereby take value in interest rate differentials. Toyota can therefore borrow in Japan, United States of America or Europe to take advantage of interest rate differentials. With the evaluate fall in the American concern rate as against the Japanese interest rate, Toyota can borrow in dollars so as to take advantage of the fall in interest rates. Theexpect fall in American interest will forget to a fall in the value of dollars in relation to the yen. This fall will make loans and other commitments denominated in dollars less expensive in yen hurt. Toyota will therefore gain from the expected depreciation of the dollar.The most obvious source or determinant of economic currency exposure comes from tights having revenues or costs denominated in foreign currencies. These direct or transaction effects are relatively slatternly 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 fir ms engaged in international business and to domestic firms, but which are substantially more difficult to recognise. This indirect economic currency exposure arises from unexpected impinge onments in foreign exchange rates changing the competitive situation of the firm and which affect the firms future cash flows (and hence value).GLOBAL ECONOMIC FORECASTINFLATION DIFFERENTIALSThe exchange rate stated simply is the price of one currency in terms of some other currency. Exchange rate can therefore be expressed in terms of the law of one price which states that in the presence of a competitive market structure and the absence of transportation cost and other barriers to trade, identical products which are sold in different markets will sell at the same price in terms of a common currency (Pilbeam, K. (1992) International Finance, Macmillan). coitus purchasing power parity says that the change in the price level of commodities in one country relative to the rate of change in price levels in another country determines the exchange rate between the two countries. This in other words means that the rate of inflation in one country relative to another determines the rate of change in their respective currencies. (Ross et al, 1999). Thus if there is high gear inflation in one country in relation to others, prices of goods and function will increase in that country in relation with others and exchangerates have to change accordingly in rejoinder to inflation differentials.According to the World Economic Outlook of the International Monetary Fund (http//www.imf.org/external/pubs/ft/weo/2002/02/pdf/appendix.pdf accessed on 14th November 2002), inflation is expected to move from -1.40% in 2002 to -1.2% in 2003 in Japan. This is 14.3% rise in inflation in Japan. Inflation in United States of America is expected to move from 1.2% in 2002 to 1.9% in 2003. American inflation is expected to increase by 58.3% whereas inflation in the Euro area is expected to decrease by 17.4%. This means that prices of goods and services in America will increase more than prices in Japan whiles prices in Europe is expected to decrease.The expected increase in the prices in America will lead to the depreciation of the dollar against the yen in order to substantiate the purchasing power parity. The relative decrease in the level of inflation in Europe as against Japan will lead to the appreciation of the Euro against the yen. The yen is therefore expected to appreciate against the dollar but depreciate against the Euro. This will affect Toyotas revenues and profits, as whatever amount is translated from dollar to yen will be lower comparatively. However, it will gain when the Euro is translated, as values will be higher after translation.BALANCE OF PAYMENTBalance of Payment measures the flow of economic transactions between the residents of a given country and the residents of other countries during a certain period of time. The use of balance of retribution data to forecast foreign exchange rates assumes a fixed exchange rate regime. The balance of payment suggests that the current account get worse as national income rises. This is because the increased income will lead to increased income will lead to increased demand for goods and services including foreign products. This will lead to an increased demand for foreign currencies and a decrease in the value of the domestic currency. The basic tendency is for domestic currency to weaken to pay for the increased imports. In a fixed exchange regime, when this falls below certain limits the domestic government will have to interpose by selling resaves of foreign currencies in the foreign exchange market (Buckley, A. 2000).The same is with surplus where instead of selling foreign currencies, the government will buy foreigncurrencies. This will increase demand or supply of foreign currencies and therefore affect the price i.e. the exchange rate. Thus if domestic income levels were to rise, the i ncrease will lead to transaction demand for money which means that if the money stock and interest rates are held constant, the increased demand can only come about through a fall in domestic prices. The fall in domestic prices will then requires a depreciation of the currency to maintain purchasing power parity. However, an increase in foreign income levels leads to a fall in foreign prices level and therefore a depreciation of the home currency to maintain purchasing power parity (Pilbeam 1993). If there is increased demand for Japanese goods and services by Americans and Europeans then the yen is likely to appreciate, as the demand for yen will increase.However, under a floating exchange system, the government has no responsibility to peg the exchange rate. The fact that the overall balance does not sum to zero will automatically alter the exchange rate in the direction necessary to obtain a Balance of Payment coating to zero (Eitman et al). If the country is running a substanti al current account deficit whilst the capital and financial account balance is zero, it will have a deficit Balance of Payment. There will be excess supply of domestic currency and the market will rid itself of the imbalance by baleful the price through the depreciation of the currency.INTEREST RATE DIFFERNTIALSThe interest rate parity theorem implies that if interest rates are higher domestically than in a finical foreign country, the foreign countrys currency will be selling at a premium in the forward market and if interest rates are lower domestically, the foreign currency will be selling at a discount in the forward market (Ross et al 1999). The link between interest rate and exchange rate is explained by the International Fisher Effect, which holds that the interest rate differential is an unbiased predictor of future changes in the spot exchange rate (Rugman et al 2000). This differential is also important in determing forward exchange rates because this rate would be that which neutralises the difference in interest rates between the two countries.If the interest rate of one country is expected to fall in relation to another country, this will make the demand forfinancial instruments denominated in that currency to fall. This fall in demand for financial instruments will lead to a fall in demand of that currency and therefore a depreciation of that currency. However, if interest rates are expected to rise in relation to other countries, there will be an increase in demand for financial instruments denominated in that currency and an appreciation of the currency. In practical terms, the international fisher effect implies that while an investor in a low interest country can convert his funds into the currency of a high interest country and get paid a higher rate, his gain (the interest rate differential) will be offset by the expected loss because of foreign exchange rate changes.The recent annunciation of a fall in the American interest rate whilst t he Japanese interest rate remain constant will lead to a fall in the demand for dollar denominated instruments and therefore a fall in the value of the dollar in relation to the yen. The Euro interest rate is not expected to change and therefore the exchange rate between the yen and the Euro may not change on the basis of interest rates.RISK MANAGEMENT STRATEGIESToyota uses a value-at-risk analysis (VAR) to evaluate its exposure to changes in foreign currency exchange rates. The value-at-risk of the combined foreign exchange position represents a potential loss in pre-tax earnings that are estimated to be 25.2 billion as of March 31, 2001 and 24.0 billion as of March 31, 2002. Based on Toyotas overall currency exposure (including derivative positions), the risk during the year ended March 31, 2002 to pre-tax cash flow from currency movements was on average 25.0 billion, with a high of 26.7 billion and a low of 22.9 billion. The value-at-risk was estimated by using a variance/ covari ance model and assumed a 95% confidence level on the realization date and a 10-day holding period. Toyota changed the model used for calculation of value-at-risk from variance/covariance method to Monte Carlo Simulation method because Toyota introduced a new system, which Toyota considers more effective for risk solicitude purposes. The prior year amounts have been restated to the fiscal 2002 presentation. (Toyota Annual Report 2002)LEADING AND LAGGING. Larger, more centralized corporations have additional options that may be employed to help control the foreign exchange risk of inter company transactions. One effective and potentially profitable approach involves leading (prepaying) payments when the payers currency is devaluing against the payment currency and lagging those payments if the payers currency is appreciating. Lagging is when a company pays its financial commitments late so as to take advantage of a devaluing currency. Leading on the other hand is paying early before a currency devalues. It serves as a means of shifting liquidness between subsidiaries to avoid bid ask spreads and take advantage of interest rate differentials (Clark E. et al 1993). Toyota should take advantage of the fall in the interest rates in United States and subsequent expected fall in the value of the dollar. The American subsidiary should pay early all monies owned to the parent company in Japan.This will give a higher value than waiting for the dollar to devalue before paying. From a company wide standpoint, the treasurer can direct leading and lagging policy in order to take advantage of the favourable effects of exchange rate fluctuations. Additionally, leading and lagging policies may be used to shift funds from cash-rich to cash-poor sorts, thereby improving short-term liquidity. However, leading and lagging is only possibly when the company has 100% ownership of the subsidiary. This is because the effect of an extended or reduced payment date alters the relative rate of return of each subsidiary. This is unfair to minority shareholders, as they do not inescapably benefit from such a practise that benefits the multinational as a whole. (Eiteman et al 2001). Toyotas subsidiary in the US has minority shareholders like commonplace Motors and these will be at a disadvantage if Toyota should use leading and lagging to manage its exposure. Inequality may arise unless the adjustment is made to reflect a subsidiarys sacrifice.NETTING. Netting inter company transfers is another form of international cash management strategy that Toyota can employ. It requires a high degree of centralization. The basis of netting is that, within a closed group of related companies, total payables will always equal total receivables. Netting is utilitarian primarily when a large number of separate foreign exchangetransaction occur between subsidiaries (Eiteman et al 2001). Thus instead of Toyota paying monies owed to and by each subsidiary, the subsidiaries can net o ff each others debt and thereby not deal in the foreign exchange market. In order to reduce the verify transaction cost, such as spread between foreign exchange bid and ask quotations and transfer fees, Toyota should establish an in house netting centre. The exposure that remainsnet payments to payeescan then be hedged in the forward market if desired.The advantages of netting are A reduction in foreign exchange conversion fees and funds transfer fees as commissions on foreign exchange transactions and funds transfer are drastically reduced. A fast settlement of obligations reducing the groups overall exposure.REINVOICING. Reinvoicing goes one step beyond the centralized approach of multilateral netting by way of a clearing centre. A reinvoicing centre buys goods from the manufacturing subsidiary or parent, without taking possession, and reinvoices other company affiliates or third parties when it sells the goods. By conducting all transactions in the affiliates functional currenc y, the reinvoicing centre bears all currency risks. This prevents the FC exposures from distorting the subsidiarys operating profit (loss). In addition, the reinvoicing centre allows for centralized cash flow management, increase international business expertise and opportunities for arbitrage. The centre also improves and centralizes banking relationships and acts as a central purchasing agent for subsidiaries.Most important, the reinvoicing centre can assess its net position on all inter company transactions and hedge in the forward market accordingly. Problems with reinvoicing centres are* Some countries prohibit reinvoicing centres, as well(p) as any third-party billing (for example, France, Spain,).* They are very expensive to set up because sophisticated information systems and legal and tax expertise are required. sustain TO BACK LOANSBack to back loans is when two firms arrange to borrow money in each others currency so as to avoid the risk associated with exchange rate flu ctuation. Toyota can enter into an agreement with an American company that has a subsidiary in Japan. Toyota can then lend yen to the Japanese subsidiary of the American company and the American company in turn lends Toyotas American subsidiary money in dollars. This will reduce the risk that Toyota will have had if it had lend the money to its American subsidiary as the expected fall in the value of the dollar will have reduced the amount of yen to be received. The advantage with back to back loan is there will not be the need to change currencies as loans will have been contracted in the functional currency of the subsidiary and therefore there will be no risk. However it is very difficult to get a partner who will be prepared to enter into such an arrangement.NATURAL HEDGINGNatural hedging is to manage an anticipated exposure to a particular currency by acquiring a debt denominated in that currency. Thus if a firm has a long term inflow in one currency, the firm can acquire an ou tflow in the form of a loan in the same currency and use the inflow to service the debt. Since Toyotas main markets are the USA and Europe, it can take out loans in Euro or dollars and use the proceeds from its operations to pay for the loan. Toyota will then not have to bother about the exchange rate fluctuation, as it will be paying the loan from proceeds generated from local operations. Toyota is also asking its British suppliers to bill them in the Euro so as to reduce the risk. This is effective in eliminating currency exposed when the exposure cash flow is relatively constant and predictable over time (Eiteman et al 2001)FORWARD CONTRACTForward contract is an agreement to exchange currencies of different countries at a specific future date and at a specific forward rate (Eiteman et al 2001). If Toyota has receivables denominated in US dollars in the form of loans owed to the parent company, it can enter into a forward contract to hedge against the expected fall in the value of the dollar. When the value of the dollar depreciates, Toyota will therefore not be at risk. However, should the predictions not come true and the dollar rather appreciates, Toyota would have lost the opportunity of earning more on the spot market.REFERENCES1. BUCKLEY, A. (2000) multinational finance. 4th ed., Harlow Financial Times Prentice Hall.2 CLARK, E. LEVASSEUR, M. ROUSSEAU, P. (1993) international finance, London Chapman and Hall.3 PILBEAM, K. (1992) international finance, Basingstoke Macmillan Education.4 RUGMAN, A. M. (2000) international business a strategic management approach, 2nd ed., Harlow Financial Times/Prentice Hall.5. EITEMAN, D.K., STONEHILL, A.I., MOFFETT, M. H. (2001) Multinational business finance, 9th ed.,6.ROSS, S.A., WESTERFIELD, R., JAFFE, J. (1999) corporate finance, 5th ed., London McGraw Hill.6. (http//www.imf.org/external/pubs/ft/weo/2002/02/pdf/appendix.pdf accessed on 14th November 2002),7. (http//www.toyota.co.jp/en/ir.html accessed on 14th Nove mber 2002)8. (http//pacific.commerce.ubc.ca/xr/data.html accessed on 14th November2002)9. (http//news.bbc.co.uk/1/hi/business/873840.stm accessed on 16th November 2002)