Tiffany & Co.
Transaction and Economic Exposure
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.
Managing Tiffany’s yen-dollar exchange rate risk
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.
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
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Tiffany & Co.
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.
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