Due to the fluctuations of yen/dollar exchange rate, the new distribution agreement with Mitsukoshi gave rise to high exchange-rate exposure for Tiffany to bear. The exposure goes in the following two ways:
Economic Exposures. From 1983 to 1993, the yen/dollar exchange rate was along a down turn path (see Exhibit 1). In the past, Tiffany wholesaled its products to Mitsukoshi. Since the wholesale transactions were denominated entirely in dollars, yen/dollar exchange rate fluctuations did not represent a source of volatility for Tiffany's expected cash flows. Under the new agreement, Tiffany has to bear the risk of any exchange-rate fluctuations that will take place when it assumes the responsibility for establishing yen retail prices, holding inventory in Japan for sale, managing and funding local advertising and publicity programs, and controlling local Japanese management.
Translation exposure. Since Tiffany-Japan is a wholly owned subsidiary of Tiffany, as a public company, Tiffany has to consolidate financial report of its Japanese branch. So, an unanticipated change in yen/dollar exchange rate will effect the company overall financial performance.
Since Japan's sales in 1991and 1992 accounted for 23% and 15% of the net sales of Tiffany along with the long-run growth potential of Japanese sales, the above two sorts of risks could be severe in the case of an unexpected change of yen/dollar exchange rate. For example, when an unanticipated 10% rise of yen against dollar exchange rate comes, Tiffany will probably reconsider the inflated budgets in dollar term of Japanese advertising and publicity programs.
Considering the potential harms brought by yen/dollar exchange-rate exposures, Tiffany should actively manage the risk. Despite the huge market potential for Tiffany's jewelry in Japan, Japanese consumers became more cautious in their spending as the Japanese economy slowed down, resulting in a slumped demand for Tiffany's luxury items. And in the $20 billion Japanese jewelry market, Tiffany was just a smaller player. Although Tiffany management believed that a retail price reduction in Japan of 20% to 25% would likely gain a substantial increase in unit volume of jewelry sales, a strong yean could hurt the competitive pricing of Tiffany's products in Japanese markets. In addition, since the management of the firm had planned to rely mainly upon internally generated funds and a $100 million non-collateralized revolving credit facility to finance its operation, the possible bad financial performance brought by high exchange-rate risk will definitely hurt its financing plan.
The major objective of Tiffany's exchange-rate exposure control program is to handle appropriately the payment in yen of repurchase of inventory, which involves $87.5 million plus annual interest. From July 1993 to February 1998, Tiffany needed to pay Mitsukoshi in total inventory repurchase $87.5 million and interest payment $3.5625 million (see Exhibit 2). And so, Tiffany should manage the total amount of $91.0625 million exchange-rate exposure on a quarterly basis during a 4.5-year time period.
Unlike forward and futures contracts, foreign-exchange options provide flexible hedges against exchange exposure. With the option hedges, the firm can limit the downside risk while preserving the upside potential. Each of the three instruments has its pros and cons (see the table below).
Instruments Advantages Disadvantages
Forward Contract Negotiated fixed terms for contract base
Delivery specification tolerances
Budgeting advantages Inability to participate in price rallies
Futures Contract If price moves are favorable, the producer realizes the greatest return with this marketing alternative.
No premium charge is associated with futures market contracts. Subject to margin calls.
Unable to take advantage of favorable price moves.
Net price is subject to Basis change.
Currency Options No margin...
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