Foreign exchange risk Essay

Toyota beat spine Corporation is the worlds third largest automaker. It was established in lacquer on 28 August 1937. Apart from its 12 plants in Japan, Toyota has 54 manufacturing companies in 27 countries, employs 246700 people and securities industrys vehicles in more than 160 countries. Its majuscule as at March 2002 was 397 billion pine a fashion.Toyota is gived to the fluctuation in hostile specie supervene upon as it ope judge mainly in America, Continental atomic number 63 and Britain. It is in that locationfore affected by the fluctuation in the apprize of the US sawbuck bill, the Euro and to a littleer extent the British pound. Toyotas amalgamated fiscal statements, which argon presented in the Nipp anese hurt, atomic number 18 affected by the impertinent ex lurch fluctuation, as on the whole the amounts in the various countries currencies wipe out to be translated into hanker. Toyotas primary foodstuffs based on unit sales for vehicles for pecun iary socio-stinting class ended March 31 2002 were Japan (40%), join America (32%) and Europe (13%). Toyota is listed on the London, New York and Tokyo stock commutations.In the normal course of doing billet, Toyota employs derivatives financial instruments, including frontwards contracts and alien capital options to per get up its ikon to fluctuation in outside(prenominal) bills ex potpourri esteem. Toyota does not use derivatives for speculation and trading. (http//www.toyota.co.jp/en/ir.html accessed on fourteenth November 2002) The profitability of Toyotas operations is affected by m whatever factors including the changes in the look upon of the Japanese pine against other currencies which Toyota does business. The financial year for Toyota is from 1 April to 31 March. pertain OF FOREIGN EXCHANGE RISK ON OPERATIONThe respect of the Japanese yen has stocken generally for the past three years against the buck and the Euro though there had been periods offluctua tions. (http//pacific.commerce.ubc.ca/xr/data.html accessed on 14th November 2002). Changes in unknown tack set out affect Toyotas tax, gross margins, ope come in be, operating income, dis piazza income and retained hire. Toyotas cost and liabilities ar affected by traffic picture which relates primarily to sales proceed from Toyotas non municipal sales produced in Japan. It is in addition affected to a lesser extent sales proceed from Toyotas continental Europe sales produced in UK.Toyotas use of forward telephone permute judge contracts and bullion options is to elude outside replacement seek associated with trade receivables denominated primarily in U.S. dollars. Toyota also engages in contrasted currentness settlements with domestic counter parties. The company enters into forward contracts and grease ones palmss cash options (principally euro and dollar) to hedge certain portions of forecasted cash menstruations denominated in exotic currencies. Addit ionally, the Company enters into forward flip contracts to spark the earnings impact relating to supervene upon enjoin fluctuations on certain mo can profitary assets and liabilities. The Company enters into forward deepen contracts as hedges of net investments in international operations. This edit outs foreign exchange adventure and transaction costs in those settlements by handling receipts in the foreign currencies in which they are denominated.Toyota buys supplies from Peugeot in France and is pastce exposed to the Euro exchange outrank. It also manufactures engines in Japan for BMW. These in tends 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 mart for Toyota. Toyota has to make a conclusion as to which currency to outlay the cars. If the cars are hurtd in yen in order to avoid foreign exchange risk, Toyota volition not be competitive in those markets, as it would deport shifted the risk to its customers. If the footing is in the domestic currencies Toyota depart be exposed to foreign exchange risk. When there is a derogation or appreciation of the currencies in relation to the yen, Toyota run low be torn among changing the price to polish the change in the exchange rate.This decision bequeath depend on the price elasticity of strikefor cars among other factors. Toyota manages these risks by using forward contracts, capital market hedging and option market hedging. Toyota also enters into currency espousal to address a portion of its transaction risk. Foreign exchange forward contracts are used to limit exposure to losses, resulting from changes in foreign currency exchange place on distinguishs receivable and proceedings denominated in foreign currencies. Foreign exchange forward contracts, which are designated and sound as hedges of currency, risk on existent as sets and liabilities are included as an rack upset to foreign exchange gain or loss and recorded on the existing assets and liabilities. Foreign currency option is to minify the risks that are likely to be incurred on account receivable and anticipated transactions denominated in foreign currencies. This has lessen, but not eliminated, the effects of foreign exchange fluctuation.The preparation of Toyotas consoli ascertaind financial statements is in conformity with accounting principles accepted in the join States of America. All assets and liabilities of foreign subsidiaries are translated into Japanese yen at the appropriate year end current rank and all income and expense accounts are translated at rates that approximate those prevailing at the time of the transaction. Toyota thence uses the temporal order of rendering. The resulting translation adjustments are included as a component of accumulated income. Toyota is exposed to translation risk when the results of subsi diaries are translated into yen. The value in yen may not reflect the uncoiled value of the adjuvant, as it pass on also depend on the exchange rate mingled with the twain countries at the time of the translation.This clearnister colour in significantly when results of different periods are organism compared and among various geographical markets. The yen has been stronger in fiscal year 2000 as against 1999. According to Toyotas yearbook Reports, net tax change magnitude by 6.1% in 1999 and go across by 0.4% in 2000. If the difference in yen used for translation purposes are eliminated, net tax would have incrementd by 5.9% in 1999 and change magnitude by 11.2% in 2000 (http//www.toyota.co.jp/en/ir.html accessed on 14th November 2002). thence, even though the consolidation figure showed a decrease in net revenue in 2000, it was mainly due to the strengthening of the yen in 2000, which make dollar value smaller after translation.The value of the yen against the Eur o 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 when 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% profit 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 billion yen from favourable exchange rate. The US dollar rose to about 127 yen from a bout 123 yen a year ago. A strong dollar helps the earning of Toyota by boosting the value of overseas revenue when converted 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 local anaestheticised 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 prop erty in more than one place and thereby take advantage in come to rate differentials. Toyota can therefore borrow in Japan, United States of America or Europe to take advantage of affaire rate differentials. With the expect fall in the American Interest rate as against the Japanese care rate, Toyota can borrow in dollars so as to take advantage of the fall in interest rates. The anticipate fall in American interest depart atomic number 82 to a fall in the value of dollars in relation to the yen. This fall testament make lends and other commitments denominated in dollars less expensive in yen terms. Toyota go away therefore gain from the judge depreciation of the dollar.The most obvious source or determinant of economic currency exposure comes from warms having revenues or costs denominated in foreign currencies. These channel or transaction effects are relatively easy to aim and manage. In addition, fuddleds that also have foreign-based operations entrust have transla tion exposures that a revolt from consolidation. At the same time, there are also a number of indirect effects, which can be just as essential and apply both to firms engaged in international business and to domestic firms, but which are unquestionablely 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 firms future cash flows (and hence value).GLOBAL ECONOMIC FORECAST swelling 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 seizure of transportation cost and other barriers to trade, identical products which are sold in different markets go away sell at the same price in terms of a common currency (Pilbeam, K. (1992) Inte rnational Finance, Macmillan). Relative get strength 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 splashiness in one country relative to another determines the rate of change in their respective currencies. (Ross et al, 1999). and so if there is higher inflation in one country in relation to others, prices of goods and services will increase in that country in relation with others and exchangerates have to change accordingly in response to inflation differentials.According to the World frugal 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 excrete to the depreciation of the dollar against the yen in order to fight back the buy 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 PAYMENT difference of Payment measures the flow of econ omic transactions between the residents of a presumptuousness country and the residents of other countries during a certain period of time. The use of counterweight of payment data to forecast foreign exchange rates assumes a fixed exchange rate regime. The equilibrize 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 governance will have to intervene by change resaves of foreign currencies in the foreign exchange market (Buckley, A. 2000).The same is with surplus where instead of selling foreign currencies, the political rel ation 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 increase will lead to transaction demand for coin 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 eq uilibrize does not sum to zero will automatically alter the exchange rate in the direction necessary to obtain a eternal rest of Payment close to zero (Eitman et al). If the country is running a substantial 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 lowering 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 particular 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 indifferent 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 new-made announcement of a fall in the American interest rate whilst the 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 bottom 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 th e 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/ covariance 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 management purposes. The prior year amounts have been restated to the fiscal 2002 presentation. (Toyota one-year Report 2002)LEADING AND LAGGING. Larger, more concentrate 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 path involves leading (prepaying) payments when the payers currency is devaluing against the payment currency a nd fall behind 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. confidential information on the other hand is paying early before a currency devalues. It serves as a means of shifting liquidity 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 fire company in Japan.This will give a higher value than waiting for the dollar to devalue before paying. From a company dewy-eyed standpoint, the treasurer can direct leading and follow 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-r ich to cash-poor affiliates, 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 re felon of each subsidiary. This is raw to minority shareholders, as they do not necessarily benefit from such(prenominal) a practise that benefits the multinational as a whole. (Eiteman et al 2001). Toyotas subsidiary in the US has minority shareholders like General 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 carrys 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 in(p) group of related companies, supply payables will always equal total receivables. Netting is useful primarily when a large number of snap off 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 off each others debt and thereby not deal in the foreign exchange market. In order to reduce the bank transaction cost, such as spread between foreign exchange bid and ask quotations and transfer fees, Toyota should establish an in house netting burden. 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 speedy settlement of obligations reducing the groups overall exposure.REINVOICING. Reinvoicing goes one tonus beyond the centralized approach of multilateral netting by way of a cl earing centre. A reinvoicing centre buys goods from the manufacturing subsidiary or parent, without pickings possession, and reinvoices other company affiliates or third parties when it sells the goods. By conducting all transactions in the affiliates operative currency, 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. near 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 as any third-party billing (for example, France, Spain,).* They are very e xpensive to set up because sophisticated information systems and legal and tax expertise are required. hind end 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 fluctuation. 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 occupy 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 HEDGING rude(a) 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 outflow 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) transport CONTRACTForward contract is an agreement to exchange currencies of different co untries at a detail 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 up 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 learner 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 bu siness 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 November 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)