case write up sample 1

7/28/2019 Case Write Up Sample 1

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Tiffany & Co.

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Transaction and Economic Exposure

Tiffany & Co.

Facing Exchange Rate Risks

Following Tiffany & Co. J apans new retailing agreement with Mitsukoshi Ltd. in July 1993, Tiffany-Japan was now faced with both new opportunities and risks. With greater control over retail sales in its

Japanese operations, Tiffany looked forward to long-run improvement in its performance in Japan despite

continuing weak local economic conditions. However, Tiffany was now also faced with risks of exchange

rate fluctuations between time of purchase from Tiffany and time of cash settlement that were previously

borne by Mitsukoshi.

Historical data warned Tiffany that the yen/dollar exchange rate could be quite volatile on a year-to-year

and even month-to-month basis. Although a continued strengthening of the yen against the dollar was

observed from 1983 to 1993, there was evidence that the yen was overvalued against the dollar in 1993,

and thus a distinct probability that the yen may eventually crash suddenly.

Managing Tiffanys yen-dollar exchange rate risk

The predicted depreciation of the yen would have a potentially negative impact on Tiffanys financial

results. There are three main types of foreign exchange exposures are (1) transaction (short-term), (2)

economic (medium to long term) and (3) translation exposures.

For a company like Tiffany which has sales in numerous countries, there are a continuing series of foreign

currency receivables and payables. Thus, Tiffany should have a foreign currency hedging program to

cover these foreign exchange exposures. The objective of hedging would be to stabilize product costs,

over the short-term, despite exchange rate fluctuations. In the long-term, if exchange rate differences have

significantly changed, it is possible to adjust retail prices when necessary to maintain its gross margin.

To reduce exchange rate risk on its yen cash flow, Tiffany had two basic alternatives:

(1)To enter forward agreements(2)To purchase a yen put option

These two derivative instruments can both be used to hedge risks and reduce earnings volatility, but are

different in characteristics and have different potential risks and rewards.

Option 1: Forward Contract

A forward contract is an agreement to exchange a given amount of currency at a predetermined fixed rate

at a specified future date, customized in terms of amounts and maturities. Its maturity typically ranges

from 3 days to 1 year, but longer maturities may be available.

This contract creates for both buyer and seller both the right and obligation to transact at the specified

terms. The buyer of forward contract is obligated to take delivery of the currency at maturity date and pay


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Tiffany & Co.

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the agreed-upon price at maturity date. The seller of forward contract is obligated to deliver the currency

at maturity date and accept the agreed-upon price at the maturity date

Since Tiffanys receivables are denominated in Yen due at a future date, they face the uncertainty of the

dollar equivalent of cash flow. Thus, a forward contract can be used as an effective risk management tool

to remove this uncertainty. A forward contract would guarantee Tiffany a certain receipt at some forwarddate regardless of the spot exchange rate.

The advantage of a forward contract is that it is simple and zero cost. There is only one cash flow which

takes place at maturity. They are widely available and easily customized for specific needs. However,

there are disadvantages of the lack of liquidity and flexibility. Credit risks may be present with the

counterparty, unless the contract is written between large institutions with good credit and ongoing

relationships.

As illustrated in the diagram above, if the spot exchange rate is below the forward rate at the time the

receivable is due, then Tiffany would gain from hedging.

Option 2: Buy Yen Put Option

An alternative would be to buy a Yen put option. A key difference between a forward contract and an

option is that a forward contract gives the holder the obligation to buy or sell at a certain price. On the

other hand, an option gives the holder theright but not the obligation to buy or sell a given amount of yenat a predetermined price for a specified time period on (European option) or before (American option) a

specified maturity date.

A put option gives the holder the right to sell foreign currency. If the Yen falls, a put option would gain in

value, thus this would be an effective hedging device for Tiffany. One advantage that a put option has

over a forward contract is that the amount of loss is limited to the premium of the option, if the yen moves

in opposite direction to what was predicted.

Net USDcash flowwith forwardcontract

ExchangeRate

Forward Rate

$ received inforwardcontract

Spot Line

Hedging Gain

Hedging Loss


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Tiffany & Co.

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The most frequently used options in multinational enterprises are options on the Over-The-Counter

market (OTC). The advantage is that they are tailored to the specific needs of the firm. Financial

institutions are willing to write or buy options that vary by amount (principal), strike price (exchange rate

at which yen can be sold) and maturity. Tiffany can place a call to the currency option desk of a major

bank specify currencies, maturity, strike rate and ask for bid-offer quote the bank will then price the

option and return the call.

For example, if Tiffany has 1m Yen receivable (asset) due in 3 months, they can buy put options to

protect (set a floor) to the dollar value of Y en receivables (assets). The possible outcomes are:

(1)Spot rate Strike Price

If the spot rate is higher than the strike price, Tiffany would not exercise the option and would get (Spot

Premium) per Yen sold. The buyer of the put can never lose more than the premium paid upfront.

The diagram below shows the situation in buying a put option on Yen. Profits are calculated by: Profit =

Strike price (spot rate + premium). The disadvantage of options is that a premium must be paid.

However, although the downside result of a put option is worse than the downside of the forward hedge

the upside potential is not limited. Basically, options have almost unlimited profit potential with limited

loss potential.

Profit(USD/J PY) Strike Price

Breakeven Price

Profit Area

Area of limited loss


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Tiffany & Co.

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Recommendation for Tiffany & Co.

Overall, Tiffanys choice amongst the two hedging strategies would depend on two main factors: its risk

tolerance and its expectation of the direction and extent of future exchange rate change.

Tiffanys view of the likely exchange rate changes is relevant to hedging choice. Referring to the diagrambelow, if the exchange is expected to move to the left (i.e. against Tiffany), the forward hedge preferred,

as it would guarantee a future value to Tiffany.

However, if Tiffany is worried that expectations may prove incorrect, and perhaps the exchange rate may

move to the right, the put option would potentially allow Tiffany to enjoy upside movement and

simultaneously provide a safety net of a minimum value if the puts are exercised. Since there has been

continued strengthening of the yen against the dollar 1983 to 1993 and the evidence regarding the

overvaluation of the yen against the dollar is not certain, there is still some uncertainty about the

possibility and timing of the yen crashing. Thus, a put option would be more appropriate. Although this

risk management instrument is more expensive, if Yen continues to be strong, Tiffany can still retain the

upside gain.

Evaluation Tiffanys risk management program

As Tiffany & Co. is an international company, exchange rate fluctuations have a significant impact on thefirms financial accounts. Thus, a risk management program is very appropriate for Tiffany. By hedging

and reducing the risk in future cash flows, Tiffany will be able to improve its planning capability. It

would also reduce the likelihood of that the firms cash flow would fall below a necessary minimum to

make debt-service payments in order for it to continue to operate.

However, although currency hedging reduces risk, this does not necessarily mean adding value or return

to Tiffany. Currency risk management does not increase the expected cash flow of the firm; it normally

Value ofcash flow

Forward contracthedge

UncoveredPut OptionHedge

Put optionstrike price

Ending Spotexchange rate


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Tiffany & Co.

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consumes some of a firms resources and so reduces cash flow. Thus hedging will only add value to the

firm if the increase in value (i.e. reduction in variance in expected cash flow resulting from unexpected

exchange rate changes) is large enough to compensate for the cost of hedging.

The value Tiffany places on risk management also depends on the firms goal and management objectives.

If the firms goal is to maximize shareholder wealth, hedging activity is probably not in shareholders bestinterest as management often conducts hedging that benefit management at the expense of shareholders.

In terms of management objectives, sometimes managers are motivated to reduce variability due to

accounting reasons i.e. they do not want to be criticized for incurring foreign exchange losses in its

financial statements.

It should also be noted that contractual hedging can only cover foreign exchange exposure up to a certain

extent. In the longer term, other strategies are needed. As mentioned before, there are three types of

foreign exchange risk transaction, economic and translation exposures.

In managing economic exposure, natural hedging is more appropriate i.e. the structuring of firm

operations in order to create matching streams of cash flows by currency. This seems to have beenaccomplished by Tiffany, through its diversification internationally both in terms of operations (e.g.

diversifying sales, location of production facilities and raw material sources) and financing base (e.g.

raising funds in more than one capital market and more than one currency). Contractual approaches (such

as options and forwards) have occasionally been used to hedge economic exposures, but are costly and

possibly ineffective. Examples of common proactive policies include matching currency cash flows, risk-

sharing agreements, back-to-back loan structures, cross-country currency swaps, leads and lags, and re-

invoicing centers.

case write up sample 1

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