Tiffany & Co.
Facing Exchange Rate Risks
Following Tiffany & Co. Japan’s new retailing agreement with Mitsukoshi Ltd. in July 1993, TiffanyJapan 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 Tiffany’s yen-dollar exchange rate risk.
The predicted depreciation of the yen would have a potentially negative impact on Tiffany’s 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 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 Tiffany’s 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 forward date 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.
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 the right but not the obligation to buy or sell a given amount of yen at 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. 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 Yen receivables (assets). The possible outcomes are:
(1) Spot rate < Strike Price
The buyer of a put option wants to sell the underlying currency at the exercise price when the market price of the currency drops. In this case, Tiffany would exercise the option and get (Strike – Premium) per Yen sold.
(2) 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.
Recommendation for Tiffany & Co.
Overall, Tiffany’s 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. Tiffany’s view of the likely exchange rate changes is relevant to hedging choice. Referring to the diagram below, 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 Tiffany’s risk management program
As Tiffany & Co. is an international company, exchange rate fluctuations have a significant impact on the firm’s 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 firm’s 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 consumes some of a firm’s 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 firm’s goal and management objectives. If the firm’s goal is to maximize shareholder wealth, hedging activity is probably not in shareholders’ best interest 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 been accomplished 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, risksharing agreements, back-to-back loan structures, cross-country currency swaps, leads and lags, and reinvoicing centers.