International Financial Economics
Universiteit van Amsterdam
Question 1 Should Walt Disney Company hedge its yen exposure? Why?
On April 1983 Tokyo Disneyland started to operate. The Japanese company that operated this park paid royalties on certain revenues to Walt Disney Productions. The Yen royalties receipts in 1984 already reached a height of 8 billion Yen. The director of finance of the Walt Disney Company expected a further growth of 10% to 20% per year over the following years.
In the mean time there existed a problem of a depreciation of the Yen, the Japanese currency depreciated with almost 8% against the US Dollar. The Walt Disney Company was concerned for further depreciation of the Yen Royalties. This was because the amount of royalties was expected to grow at a high level and with a depreciation against the US Dollar this would counter its investment and expansion plans for the future.
To attempt the risk of possible exposure of Disney to future fluctuations in the Yen/Dollar sport rate, the company can choose to hedge its Yen royalties cash flows. This can be done by using financial instruments to reduce or even entirely eliminate the impact of exchange rates on the cash flows of the Yen royalties. These financial instruments include for example forward contracts, futures contracts, swaps and options.
Besides reducing the risk and impact of exchange rates and interest rates, hedging has more advantages. The first advantage is important for Disney since the appreciating Yen will reduce the US Dollar value of the increasing royalties from Japan. Hedging can be used to hold profits and surviving hard market periods, like the depreciation of the Yen. Earnings and cash flows are influenced by exchange rate or interest rate changes which avoids steadiness. With hedging Disney is also not required to monitor daily market volatility and the company can concentrate on its investing and expansion plans.
When the market is performing well or moves sidewise the benefits of hedging can decrease or in the worst situation disappear. When the Yen for example starts to appreciate or if the Dollar falls, Disney won’t be able to obtain the total benefits which it would have received without hedging. Various ways of hedging can be seen as speculation, which also involves the giving up of diversification. Another problem Disney confronted was that in the 1980’s futures and option contracts in liquid markets only had maturities of a maximum of two years and long-term forward contract quotes showed very large bid-ask spreads. Hedging is also for a part based on expectations, Disney based the hedging on increasing royalties from Japan but this could change anytime in the future.
Walt Disney Corporations received an amount of almost 8 billion Yen in royalties during the fiscal book year of 1984. This was an amount of approximately 33.7 million U.S. Dollars. In the first years the Yen income was just a small part of the total income of Disney, but it was expected to increase at high levels in the coming years with 10% to 20%. This implied that the part of income from Yen royalties would grow to bigger amounts. This implied for attempting risks. In this way the advantages for hedging are more important because the increasing Yen royalties are protected against exchange rate risks. This way the company can safely conduct its financial plans of investments and expansion.
Question 2: Discuss briefly the main hedging techniques WD may adopt. Walt Disney has several possibilities to hedge its position with respect to the future Yen inflows. The main problem as stated in the answer to question 1, is that Walt Disney wants to lower its exposure to future fluctuations in the yen/dollar spot rate and reduce its short-term debt. In this case, we will discuss the following hedging techniques: 1 Foreign exchange (FX) options
Foreign exchange options have the advantage...