Critical examination of exchange rate changes on the financial performance of Honda Motors - Essay Example

Critical examination of exchange rate changes on the financial performance of Honda Motors Overview: This research assignment explores the significance of financial derivative instruments to cover the currency risks faced by Honda Motors, one of the truly global automobile MNC’s which has a sizeable market presence in all continents. The main parts into which the research has been divided are: 1. A brief description of the background/operations of the company. 2. A critical evaluation of the company’s strategy in managing currency risk, for two significant currencies, for the financial years 2004, 2005 and 2006. The currencies chosen are Japanese Yen ¥ and US Dollar, $. 3. An assessment of the potential impact of forecast changes in exchange rates upon the company’s revenues and profits, for the next financial year, 2007. 4. An assessment of the risk management policies that should be pursued in 2007 by the company in lieu of current scenario. 5. A critical appraisal of the likely problems the company is going to face in implementing the risk management strategies identified earlier. 6. Summary of findings 1 Background of company: Founded in 24 Sept, 1948 by Soichiro Honda, Honda Motors, headquartered in Tokyo, Japan, is a prominent auto major with indigenous operations in different countries of the world. In the USA, it is called Honda USA; in the UK, Honda UK, and so on. Its famous brands popular with International markets are: Civic, Accord and CR-V. It is the undisputed King in the motorcycle market, with sales of 14 million units per year. It is also a major player in different racing car arenas, e.g. Grand Prix, the US NASCAR rally and other turfs. Its brand slogan is “The Power of Dreams”. Honda’s revenues in 2006 stood at ¥9908 billion against net profits of ¥597 billion (Honda Annual Report, 2006). ($1=¥118). Its shares are traded at multiple stock exchanges in the world; the New York Dow Jones, Tokyo’s Nikkei, Hong Kong’s Hang Seng, London’s FTSE 100 and may others. Along with Toyota, Mitsubishi and other Japanese car makers, Honda has achieved a large part of its business success by pushing for a very high scale of production, and benefiting from economies of scale and learning curve effects. According to leading market strategy experts (Hamel & Prahlad, 1989), Honda’s core competence lies in its focus on leadership in the field of internal combustion engines. Honda’s entry into the US and British markets, is often used as a case study for teaching Corporate Strategy in B-schools. 2 A critical evaluation into Honda’s strategy in managing currency risk for significant currencies: 2.1: Analysing two significant currencies in the company’s global activities: For this research assignment, the currencies discussed are Japanese Yen, ¥, and US Dollar, $, the reason for doing so is in keeping with Honda’s currency invoicing practices of documenting global sales in US currency (Dominguez, 1998, p.2) only. Looking ahead, we shall look into the company financial reports for the past 3-4 years. The first basic question that comes to the mind: why do global MNC’s need to manage currency risks in the first place. According to the classical trade theory of “competitive advantage” developed by Adam Smith and David Ricardo, each nation should specialise in the production and export of those goods that it can produce with higher relative efficiency, and import those goods that other nations can produce with higher relative efficiency (Shapiro, 2004, p.4). In recent years, the 1980’s and 1990’s, International trade is operating at a much higher level of competitive advantage, thanks to fundamental political, technological, regulatory and economic forces changing the global scenario. Some of these forces are (Shapiro, 2004, p.5): 1) massive deregulation 2) the collapse of Communism 3) rapid privatisation around the world 4) the revolution in Information Technologies 5) The rise in corporate takeovers, mergers and leveraged buyouts. All these forces have ushered in an era of brutal price and service competition, which collectively raise uncertainty in international markets in terms of growth and recession, prices of raw materials, behaviour of equity markets, and finally, the exchange rates of different currencies (Shapiro, 2004, p.187). This sets up patterns, like the unprecedented rise of the Pound over the Dollar in the last 10 years (today, it is almost double). Honda and its subsidiaries provide finance for its automobiles, and maintain their books of accounts in conformity with financial accounting standards of Japan. Following are the key risk factors affecting Honda worldwide (Honda Annual Report, 2006): 1. Market conditions: Honda conducts its operations in almost all countries around the world, which may be facing economic slowdowns, recession or sustained loss of consumer confidence in these markets. 2. Currency fluctuations: Automobile is a complete assembly product which is made of raw materials sourced from different countries. Variation in national exchange rates, causes undesirable fluctuations in costs. Since Honda exports many products and components from Japan, and generates a substantial portion of its revenues in currency other than Yen, Honda’s results are adversely affected by the appreciation of the Yen against other currencies, especially the US dollar. 2.2: Analysing Honda’s strategy in counteracting currency risks: The main financial instruments used by MNC’s like Honda for shelving off currency risk are (Shapiro, 2004): foreign exchange spots (buying and selling of foreign currency at prevailing rates) (p.187), futures (standardised contracts to trade in foreign currency in the future, at a pre-set price) (p.210), forwards (bi-party contracts to buy/sell the currency in the future, at a pre-set price in order to minimise currency exposure risk) (p.201), options (contracts that give the party, the right, but not obligation to buy or sell on a pre-assigned date) (p.215), and swaps (Over the Counter bi-party contracts negotiated “outside” the exchange) (p.234). Two terms commonly used are Translation exposure (change in company equity, assets and income due to exchange rates change) (p.269), and Transaction exposure (the exchange rate risk associated with the time delay into entering a contract, and settling it) (p.271). More on these derivatives in Honda’s context right ahead. What these trends mean in real terms, Honda has a duty to enter into foreign exchange agreements to manage currency rate exposure. These instruments mainly include foreign currency forward contracts, currency swap agreements and currency options contracts (Honda Annual Report, 2002, p.39). As a written policy, the company is signatory to Statement of Financial Accounting SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and SFAS No. 138, “An amendment to the above”, gains and losses on foreign exchange instruments that qualify for hedge accounting treatment were recognised in the same period in which gains or losses from the transaction being hedged was recognised (Honda Annual Report, 2002, p.39). In the event of an early termination of the hedge, any deferred gain or loss on the hedging instrument was deferred until the hedged item was realised. Derivative financial instruments that didn’t meet the criteria for hedge accounting, were not included (Honda Annual Report, 2002, p.39). The Financial Accounting Standards Bureau as clarified thus, establish accounting and reporting standards for derivative instruments and for hedging activities, and require that an entity recognise all derivatives as either assets, or liabilities in the balance sheet and measure those instruments at fair value. The ineffective portion of all hedges is recognised as loss. Honda also has Foreign currency translation practices. Currently, the company makes it a policy to translate all overseas dealings in Japanese currency, on the basis of the year-end rates for all assets and liabilities, and the weighted average rate for the year, for all income and expense amounts. Translation adjustments resulting thereof, are included in other comprehensive income (loss) and are accumulated in the stockholders’ equity section of the consolidated balance sheets (Honda Annual Report, 2002, p.39). Foreign currency receivables and payables are translated at applicable current rates on the balance sheet date. All revenues and expenses associated with foreign currency are converted at the rates of prevailing exchanges when such transaction occurs. The resulting exchange gains or losses are reflected in other income. Honda has a policy of combining all derivative instruments impact in a single category called, transaction losses, which is the combined value at risk, for the consolidated balance sheets (Honda Annual Report, 2002, p.39). From study of financial reports of 2004, 2005 and 2006, the combined values for foreign exchange transaction gains (or losses) for Honda’s worldwide market presence, is given as: for 2004, it stood at ¥13,688 million in profit (Honda Annual Report, 2004). For 2005, it stood at ¥17,146 million in losses (Honda Annual Report, 2005). For 2006, the currency losses rose steeply to ¥38,880 million which equates $331 million (Honda Annual Report, 2006). The losses happen mainly due to adjustments made through intercompany loans, against a weakening Yen, which has unexpectedly, and continuously fallen against the US dollar over the past two years. The only way these losses can be avoided, is by following proper models for pricing, and macroeconomics, such as the Black Scholes model, as discussed in upcoming section. The amount recognised in earnings included in other income (expenses) ending March 31, 2004, 2005 and 2006 stood at ¥122,583 million gain, ¥44,905 million gain and ¥55,516 million ($473 million) loss respectively (Honda Annual Report, 2006). In relation to this, the company included gains and losses on translation of debts of finance subsidiaries denominated in foreign currencies intended to be hedged of ¥36,410 million loss, ¥10,667 million gain and ¥45,046 million gain in other business expenses for the same time In addition, net realised gains and losses on currency swaps, not recognised as accounting hedges by financial subsidiaries of ¥38,894 million loss, ¥28,000 million loss and ¥827 million gain ($7 million) are presented on a net basis (Honda Annual Report, 2006). So far, we discussed Honda’s currency exchange rate management strategies for its worldwide operational presence. The $331 million costs recorded in 2006, makes a dent in overall profits for the company, and having said that the automobile sector is extremely vulnerable to cross-currency fluctuation rates, the risk factors only get compounded. Japanese companies are usually deficient in recording the specifics of currency rate hedging activities (Dominguez, 1998, p.2), but the information recorded above gives an indication to the level of protection measures drawn by concerned companies like Honda. 3 An assessment of the potential changes in exchange rates of significant currencies, on the future of Honda, in lieu of revenues and profits: In this section, we will analyse the impact on Honda’s business plans, based on potential changes in exchange rates of the US dollar against the Japanese Yen, for understanding the impact that may be there due to currency fluctuations. It has been discussed earlier, that the company registered losses on currency hedging activities, due to an unprecedented decline in the value of Yen against the dollar. Such a situation can be best avoided by appropriate study of currency rate fluctuation patterns. We start with an elementary discussion on financial theories related to this field of study. In order to offset any undesirable impact due to volatility in currency exchange rates, companies have to strategywise, forecast their long-term response to fluctuations in exchange rates in their worldwide operations. The following discussions set the benchmarks in providing a meaningful picture of how currency fluctuations may affect the revenues and profits of a company such as Honda. According to Chen (1998), financial analysts in such companies usually follow a precise option pricing model and a good macroeconomic theory to better predict future changes in exchange rates and their derivatives (Chen, 1998, p.2). For the former, they use an economic equation used to calculate the payoff for a currency call option (just an example) may be given as (Chen, 1998, p.8): PFEC = Max[S() - K, 0] -(i) where S() and K stand for the underlying asset price at maturity, and the strike price of the option. From its definition, it can be assumed that a buyer would expect a positive pay-off once he is able to determine whether the value offered by any currency option, is going to yield a higher positive value for the underlying asset price at maturity. This, usually is done through simplistic speculations, but is backed by comprehensive study of market data in stock exchanges and equities. A company like Honda utilises the services of chartered accountants to realise when it should launch a currency option, in order to achieve good payoff in the longer run. Apart from the option pricing model, Honda has to study a solid macroeconomic theory to evolve a more precise picture of the exchange rate markets. Chartered accountants almost universally, use the Black Scholes model. which studies the implied volatility in prices of foreign currency options. It is a mathematical model of the market for an underlying security such as currency option, in which the security’s price is a stochastic (mathematical) process. Using the Black Scholes model, financial analysts in Honda try to solve the resulting partial differential equation, which ultimately leads to a formula for the price of a call option with exercise price K, on a security, currently trading at price S, after T years. The equation is given as (Fischer & Scholes, 1973): C(S,T) = SN (d1) – K.e.-r.. N.(d2) -(ii) where d1 and d2 are mathematical constants. Using the results derived from the above macroeconomic model, we are able to calculate the volatility of the Yen against the Dollar. In practice, the volatility surfaces (statistical graphs drawn) are seldom flat, they tend to have skewed curves: a typical approach is to regard the volatility surface, as a fact about the market, and use an implied volatility from it in a Black Scholes valuation model. The results obtained herein, also give the values of hedge ratios, that the company must follow for launching currency options (Black & Scholes, 1973). At Honda, the summation of essential discussions above, and the fact mentioned in previous section that the company made huge losses in utilising currency derivative instruments for two consecutive years, the following reason shows how the impact on bottomline revenues was affected by derivative instruments. As the bulk of Honda’s exports are denoted in US dollars, the consequences of dollar invoicing depends on the extent to which it hedges the dollar exposures (Dominguez, 1998, p.1). If it fully hedges the dollar exposure, then the choice of invoicing currency does not impact the Yen profits of Japanese companies. The fact that the Yen appreciated by over 250% in the period 1970-74 (Dominguez, 1998, p.8), did not deter Honda and likewise, other Japanese companies from remaining exposed to dollar risk. There is a strong tendency for managers to justify the purchase of derivatives, that was not necessary. Consequently, only in periods of exchange rate volatility, do managers find that it was necessary to go for hedging alternatives in their scheme of plans. In addition to the financial theories to be pursued by the company , the future is optimistic for Honda’s worldwide operations in lieu of forecasts in the Japanese currency valuation against the US dollar. According to the Financial Forecast Center, a small, privately-owned Texas-based Corporation, the Japanese Yen is 80% poised to appreciate against the US Dollar from 118 today, to around 114 by April 2007 (FFC, 2006). This would happen because the US economy is coming out of a two-year recession period, and poised for a period of stable growth, an optimism that a more permanent increase in the value of the Yen will probably require a shift in global liquidity, in line with that of Spring 2006. A gradual improvement in the US economy is good news for Honda, since that entails enhanced consumer confidence. But, there is a catch! With any potential decline in the exchange rates between the Dollar and the Yen, we must make an integrated assessment of the risks that Honda could face in the next financial year. There are both pros and cons to this aspect. Steep and long-term shifts in exchange rates create discrepancies in cost and revenue models, resulting in operational and strategic risks (Deloitte Research, 2006, p.2). Exchange rate risks can create risk exposure across Honda’s global network of supply chains. However, a rise in Dollar would mean that its offshore facilities would have a relief on input material and shipping costs. On the plus side, the company will not need to burden overseas customers, with higher prices, and this can boost sales and profits. Also, Honda has to perform an exchange rate exposure analysis (based on 2 models discussed here) around their global competitors. The sum total of risks experienced by Honda, due to exchange rate problems, can be summarised as (Deloitte Research, 2006, p.2): 1. Strategic risks such as fall in demand, and inability to diagnose competitor move. 2. Operational risks such as cost revenues, supply chain failure etc. 3. Financial risks such as poor financial management, asset losses and trading losses, etc. A seasoned approach to counteract these risks is to go for operational hedging, which is done through adjustments in supply chains, financial positions, distribution patterns and market-facing activities. When deployed, these measures can reduce the impact of long and prolonged shifts in currency values based on cost and revenues (Deloitte Research, 2006, p.2). More on this right away. 4 An assessment of the risk management policies that should be pursued in 2007 by the company in lieu of current scenario In this section, we shall try to form a broad framework of risk management policies, that should be pursued by Honda, for its upcoming operations in 2007. Our main focus is on operational hedging which when, deployed carefully can reduce the impact of large and long-term shifts in currencies based on costs and revenues. As proved through two continuous years of loss-making at Honda, it should be seen that “traditional responses” to eliminate exchange rate risk from the cost-revenue equation, aren’t enough. These traditional responses include financial hedging strategies through financial instruments, carrying large cash balances (what are known as hedge funds) and borrowing in US Dollars (Deloitte Research, 2006, p.3). These financial hedging techniques for Honda, have been elaborated in Section 2. They certainly offset the impact of short-term currency fluctuations, but they are incapable of providing for long-term uncertainties, e.g. the exchange rate losses recorded in 2005 and 2006. This is because long-term exchange rate risks lead to uncertainty in future cash flows, as opposed to uncertainty of the exchange rate at which cash flows will be converted (Deloitte Research, 2006, p.3). For Honda, one more reason for losses in 2005 and 2006, has been the reason that long-term hedging quickly becomes expensive because the derivative premiums are proportional to the degree of perceived risk and the time duration for which they are issued (Deloitte Research, 2006, p.3). For Honda’s operational hedging risk management framework would mitigate the Dollar-Yen uncertainty, by providing the company operational flexibility, in terms of supply chains, financial position, distribution patterns and market-facing activities so they can make swift adjustments to where they manufacture, source and sell (Deloitte Research, 2006, p.3). It involves decisions regarding the location of production facilities, sourcing of inputs, choice of logistics network, product design and offerings, choice of markets, pursuing opportunities in these markets (Deloitte Research, 2006, p.3). The objective is to manage the sensitivities in cost and revenue, so as to offset the exchange rate risks while managing the competition position. Operational hedging strategies can be crafted by assessing the likelihood of various risks, and the magnitude of their impact on cost and revenue elements (Deloitte Research, 2006, p.3). Following risk management policies should be integrated into Honda’s overall strategy, to successfully manage any event of currency risk in 2007: 1. Continuing with financial instruments as safeguards to short-term fluctuations. 2. Relocating manufacturing and strategic supply bases to final markets: Since the United States is a major market for Honda’s cars, it can consider building more production facilities there, to offset the impact due to currency fluctuations between the Dollar and the Yen. 3. Optimising sourcing and supply chain networks to limit Yen weakening risk: This feature addresses exchange rate risks using issues such as cycle time, transportation cost, duties, taxes, insurance and financing costs. 4. Redirecting sales and marketing investments towards stronger currency markets: This is the best deterrent to currency fluctuations. Considering the relentless march the British Pound and Euro have over the Dollar, and the trend not reversing anytime soon, Honda must make a more aggressive pitch for these high-dividend markets. 5. Pursuing Exports through Product Development to enhance presence in stronger currency markets. 6. Increased productivity in off-shored and outsourced operations A critical appraisal of the likely problems the company is going to face in implementing the risk management strategies identified earlier Having clearly outlined the risk management framework for Honda as its financial strength pillar, it is important to highlight the limitations in achieving results with such policy initiatives. According to Guay and Kothari (2003, p.437), there is a huge “difference” between the amount of money that a firm wants to hedge with derivatives, and the amount that it actually succeeds in hedging. In previous section, we discussed the relative importance of different hedging options for Honda’s case. But, it is not an easy route as it is fraught with some practical limitations, which we shall study on an individual case by case basis. 1. Continuing with financial instruments as primary safeguards: Three major problems with financial instruments are inconsistency, asymmetry and indeterminacy (Weisbach & Blum, 2005). Inconsistency refers to the wide gaps in hedging schemes with a complicated web which can make auditing a difficult task. Asymmetry refers to the unreliable nature of the entries itself, and indeterminacy refers to the probability of fraudulent data entry. If these problems with financial instruments are not sorted out in the beginning itself, it could lead to a colossal financial disaster, the likes of Nick Leeson. 2. Relocating strategic production facilities to final markets: Since the majority of sales revenues for Honda, comes from stronger currency markets, relocating production facilities, engineering and design teams, and raw materials may require a starting investment, which can take a few years to pay-off. However, seen in the context of the company’s long-term growth scenario, such an investment should be seen in the context of long-term growth, and not immediate returns. 3. Optimising sourcing and supply chain networks to reduce currency risk: Supply Chain optimisation problems are very large and complex, due to the interactions of the entities, the lengths of the supply chains, the lead times of manufacturing and shipping, the complexities of modelling the individual entities, the stochastic nature of demand and supply, etc. Thus, delivering diligently on this task is easier said than done, and a lot depends on Honda’s internal processes strength, if it has to meet with success in this method. 4. Redirecting sales and marketing efforts in stronger currency markets: We have discussed Europe’s importance, in relation to Honda’s new market base. The biggest limitation to any aggressive sales pitch, is “competition”. Honda has several competitors in each segment of the automobile market, and beating competition requires a result-oriented SWOT analysis, and a winning strategy. 5. Product development: Honda does innovate with new models of automobiles each year. A new product with the right ingredients of the 4P’s (Product, Price, Promotion and Place) can boost sales in the right niche market, and offset most of the currency fluctuations discussed. 6. Increased productivity: Again, this is easier said than done. It is no mean task for a company to revamp its existing processes, to come with better solutions for improving productivity. Summary: Following are essential conclusions made from this research assignment on Honda’s tryst with exchange rate problems: 1. The US Dollar is the most significant currency for invoicing purposes for Honda, after Japanese Yen of course. 2. For the last 2 years, the company has recorded substantial losses in currency hedging activities, mainly due to failure in arriving at an appropriate pricing model, and macroeconomic analysis, the solution discussed below. 3. The company uses a combination of financial analysis studies, a summation of Options Pricing model and the Black Scholes theory for calculating the volatility of currency markets. Using data prepared from this study, the company uses different financial instruments. For better results in 2007 and future, the company should also consider the Optional Hedging model (6 points) and their limitations. Word count: 4047 Sources Black, F., & Scholes, M., (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy 81 (3): p.648 Chen, Z.H., (1998, March 1). Currency options and exchange rate Economics. World Scientific, p.2-8 Deloitte Research, (2006, June). Managing in the face of Exchange rate uncertainty: A case for Optional Hedging, Deloitte Research Study, Deloitte Touche Tohmatsu. Dominguez, K., (1998, October). The Dollar Exposure of Japanese Companies. The University of Michigan Research Seminar in International Economics, Discussion Paper No. 414, p.1-8. Financial Forecast Center, (2006, Nov 8). Japan Yen to US Dollar Currency Exchange Forecast for 2007. Available: http://www.forecasts.org/yen.htm [14 Nov 2006]. Guay, W., & Kothari, S.P., (2003). How much do firms hedge with derivatives?” Journal of Financial Economics, 70, p. 437 Honda Annual Reports, (2002, 2004, 2005, 2006). Available: www.world.honda.com Prahlad, C.K., & Hamel, G. (2002. October). The Core Competence of Competition. Cambridge: Harvard University Press. Shapiro, A., (2004, March). Foundations of Multinational Financial Management. New York. John Wiley & Sons, p.4-271. Weisbach, D.A., & Blum, W.J., (2005, March 3). Problems with the taxation of financial instruments. University of Chicago Law School, p.2-6. Read More