Foreign Exchange Risk - Honda Motor Co - Essay Example

Question Foreign exchange risk is one of the most common risks that any multinational or a firm having international operations confronts. These international operations might be in the form of manufacturing, exporting, importing and retailing. A manufacturing concern would be exposed to foreign exchange risk if it is operating in a foreign country by means of subsidiaries etc. Manufacturing operations in a country with highly unstable foreign exchange is ultimately exposed to foreign exchange risk. The depreciation or appreciation of exchange rate in any of the two countries, the domestic as well as international market, would have a significant impact on the firm’s revenues and future cash flows. Exporting and importing also implies considerable foreign exchange risks for the companies involved. Importers will have to pay a higher price if their home currency depreciates against the exporting foreign country and vice versa. International retailing operations also entail high exposure to foreign exchange risk as the exchange rate of any of the two countries fluctuates. The fluctuations in exchange rate “…result in direct changes in the relative prices of domestic and foreign goods…” (Bartov and Bodnar, 1994, p. 1758) It ultimately increases the exposure of virtually all forms of international operations to foreign exchange risk. Foreign exchange or currency risk affects a company in several different ways viz. sales level, future cash flows, financial reporting, product price and production etc. Bartov and Bodnar propound that exchange rate fluctuations “…influence both the current and future expected cash flows of firms with international operations.” (1994, p. 1758). Fluctuation in exchange rate can affect a company’s future cash flows by increasing or decreasing the price of goods and services in the domestic or foreign country. It can also affect a company’s operational performance by increasing or decreasing the cost of importing raw material. Currency rates have a significant impact on the reporting of sales level. If the foreign exchange rates are favourable, the company’s reported sales will rise (Bartov and Bodnar, 1994). Therefore, apart from affecting its real future cash flows, exchange rate fluctuations bear the capacity to influence its reported revenues. Exposure to foreign exchange risk can also affect a company’s production level and its prices. It will be costlier for companies to import products from a foreign country having a high exchange rate as compared to the domestic market. It will consequently reflect in the companies’ production and price level. Miller says that “often associated with the movements in aggregate production and prices are uncertain movements in exchange rates.” (1992, p. 315) Therefore, exchange rate risk can affect a company’s operations and performance in various ways. The more the fluctuations in exchange rate of domestic or foreign currency, the higher the risk. Question 2: 1): Honda Motor Co. Ltd is a multinational company having its business operations all over the world and thus is exposed to foreign exchange risk in several ways. The company has manufacturing operations in different parts of the world and it also exports from several countries including Japan. Besides, it purchases parts and sells its products in international markets including the US and European countries in foreign countries. This all makes the company severely exposed to currency risk enabling foreign exchange fluctuations to greatly affect its operations and performance. Not only that the foreign exchange risk has a great impact on the company’s real cash flows and revenues, but it also affects the company’s reported revenues and earnings. Because of the company’s operations in different countries of the world, fluctuations in exchange rate of any of these countries would affect the company’s production and price level. Honda Motor Co. Ltd purchases parts and other goods from different parts of the world involving several foreign currencies. This exposes the country to exchange rate risk which can ultimately affect the product pricing making it either expensive for the company to purchase parts in case of unfavourable exchange rates or cheaper in case of favourable foreign currency. Thus it will reflect in the prices of the company’s product making them go up or down. Changes in the rate of exchange of foreign and domestic currencies also affect Honda Motor Co. Ltd on the reported earnings, performance and position. The company exports its product parts from Japan and most of the company’s sales revenue comes from several foreign currencies. An appreciation or depreciation of Yen against the foreign currencies, in particular, the US dollar can have a significant impact on Honda Motor Co. Ltd’s financial results. It is because export and import price depends directly upon the rate of foreign exchange. If Yen depreciates against the US dollar and the price is paid in the US dollar, the company will have to pay more to purchase goods from Japan. This will definitely affect the Honda Motor Co. Ltd revenues, expenses and consequently on its earnings. 2): The annual report of Honda Motor Co Ltd for the year 2006 suggests that the company is highly exposed to foreign exchange risk because of its international business operations. It is also evident from the company’s annual report that it endeavours to manage currency rate risk with the help of hedging. The company solely uses two derivative financial instruments i.e. forward contracts and currency options to hedge against the foreign exchange risk. The following paragraphs elaborate the strategies mainly used by the company. In order to manage its exposure to foreign exchange risk, the strategies that the Honda Motor Co. Ltd utilises include hedging with the help of derivative financial instruments. The company manages currency rate fluctuations by using instruments like foreign currency forward contracts, currency swap agreements and currency options contracts. In an effort to make these hedging instruments work towards minimising the company’s exposure to risk, Honda Motor Co. Ltd deals only with counterparties that have established credit record such as major international banks and financial institutions. The company uses this strategy so as to avoid any risk concerning the default of counterparties in meeting their obligations. This strategy is one of the most common risk management strategies used by multinational corporations. Miller illuminates that “financial hedging instruments are widely used by multinational enterprises to manage foreign exchange risk.” (1992, p. 320) This strategy used by Honda Motor Co. Ltd is therefore considered to be very important in the course of risk mitigation. The company uses derivative financial instruments to hedge against fluctuations in currency rate in different aspects of its business operations. Because of the fact that company has its operations throughout the world, selling contracts are mostly denominated in foreign currencies such as US dollar, Euro, pound sterling, Canadian dollar etc. Any fluctuations in these currency rates could have a serious impact on the profitability of Honda Motor Co. Ltd. In order to manage the risk of fluctuation in any of these currencies on sales revenues, the company hedges its sales contracts dominated in foreign currencies with the help of foreign currency forward contracts and purchased option contracts. This strategy is effective in managing the company’s exposure to foreign exchange rate risk. Allayannis and Ofek also say that “the use of currency derivatives significantly reduces firm exchange-rate exposure.” (2001, p. 283) Honda Motor Co Ltd uses this widely accepted strategy of minimising foreign exchange risk with the help of currency derivatives. It is also important to note that the use of forward contracts is also effective in minimising foreign exchange risk involved in foreign currency transactions. Geczy, Minton and Schrand propounds that “forward contracts provide a relatively low-cost method for matching the payoffs of frequent and uncertain transactions.” (1997, p. 1332) Forward contracting is one of the two financial derivative instruments Honda Motor Co. Ltd uses to hedge against its exposure to foreign exchange risk. This method is considered as not only effective in managing the currency rate fluctuations but it is also regarded as cost-effective. Therefore, studies suggest that these two derivative financial instruments that the company uses can, to a great extent, minimise its exposure to exchange rate fluctuations. The company offsets the risk of premium payment on purchased option contracts by entering into foreign currency written option contracts along with these purchased option contracts. Honda Motor Co. Ltd, therefore, has devised its strategy in a manner that could guard the company against any fluctuations in the currency rates. However it is noticeable that the company has not included other financial instruments for instance swaps and foreign dominated debt etc in its strategy to hedge against currency rate risk. Geczy, Minton and Schrand suggest that “foreign-denominated debt can also act as a natural hedge of foreign revenues, thereby decreasing a firms foreign exchange-rate exposure.” (1997, p. 1331) Despite the importance of foreign dominated debt in serving as hedge against currency rate fluctuations, the company has not mentioned the usage of this technique as a part of its strategy. The company only uses derivatives i.e. forward contracts and currency options written and purchased to hedge against fluctuations mainly in US dollar, Euro, Canadian dollar and GBP etc, as mentioned in the company’s annual report 2006. References Allayannis, G. and Ofek, E. (2001). Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives. Journal of International Money and Finance, 20, pp. 273-296 Bartov, E. and Bodnar, G.M. (1994). Firm Valuation, Earnings Expectations, and the Exchange-Rate Exposure Effect. The Journal of Finance, 49(5), pp. 1755-1785 Geczy, C., Minton, B.A. and Schrand, C. (1997). Why Firms Use Currency Derivatives. The Journal of Finance, 52(4), pp. 1323-1354 Miller, K.D. (1992). A Framework for Integrated Risk Management in International Business. Journal of International Business Studies; Second Quarter, 23(2), pp. 311-331 Read More