Tiffany has decided to sell direct in Japan as opposed to selling wholesale to Mitsukoshi and Mitsukoshi selling to the public. In this agreement Tiffany will give Mitsukoshi 27% of net retail sales in exchange for providing the boutique facilities, sales staff, collection of receivables, and security for store inventory. This new agreement exposes Tiffany to the fluctuation in the yen-dollar exchange rate. Therefore, they are considering two basic hedging alternatives to reduce exchange-rate risk on their yen cash flows. The first alternative was to sell yen for dollars at a predetermined price in the future using a forward contract. The second alternative was to purchase a yen put option allowing them to exercise their option only if it was more profitable in the future at the future spot rate. Two more alternatives that we think are appropriate are a synthetic forward using options and a synthetic forward using interest rate parity. Furthermore, Tiffany needs to understand the hedging alternatives and determine what, if any, strategy is right for them.
1.In what ways is Tiffany exposed to exchange-rate risk subsequent to its new distribution agreement with Mitsikoshi? How serious are these risks?
Tiffany is exposed to foreign exchange risk by selling directly to the Japanese market. When they sold wholesale to Mitsukoshi, Mitsukoshi bore all the foreign exchange risk. Under this new agreement Tiffany is now exposed to the volatile fluctuations in the yen-dollar exchange rate. Since Tiffany is making profits in yen they have to convert the yen to dollars to take back to their home country. Since the yen is thought to be overvalued in comparison to the dollar, the future exchange rate can decrease Tiffany's profits. Also, the extreme volatility in the exchange rate creates significant uncertainty in what the future exchange rate and profits will be if left unhedged. The most important foreign exchange risk facing Tiffany is the operating exposure risk. The other types of foreign exchange risk to be taken into consideration in order of importance are transaction and translation risk. Operating exposure - is created by changes in the amount of future operating cash flows caused by an exchange rate change. This is the most important source of future exchange risks and is difficult to hedge. Exchange gains or losses are determined by changes in the firm's future competitive position and are real. This risk impacts revenues and the costs associated with future sales and should be looked at long term. Therefore, Tiffany is exposed to this risk; if the yen depreciates against the dollar, Tiffany's will receive fewer dollars. Transaction exposure - results from existing contracts that are binding future foreign currency-denominated cash flows and creates a risk to the net present value of the contracts. Tiffany is exposed to this risk because they have agreed to reverse $115 million in sales. Only $52.5 million in inventory was repurchased from Mitsukoshi in July 1993. Mitsukoshi agreed to accept a deferred payment of $25 million to be paid in yen quarterly over the next 4.5 years. The remaining inventory will be repurchased throughout February 1998. Translation risk - is created by changes in income statement items and book value of assets and liabilities caused by changes in the exchange rate. This risk relates to past activities which already appear on the balance sheet and income statement, therefore this type of risk is not serious because it does not affect Tiffany's distribution agreement with Mitsukoshi.
2.Should Tiffany actively manage its yen-dollar exchange rate risk? Why or why not?
Tiffany should actively manage its yen-dollar exchange risk. Tiffany knows they will have a substantial amount of yen cash inflows from their new arrangement of selling direct in Japan. If Tiffany does not hedge this currency exchange risk then their earnings will fluctuate....