Â Evaluation of BMWâ€™s transaction and operating exposure
Due to external factors affecting negatively, such as, the ongoing weakening of US dollar and currencies like, yen in which the company, is operating is leading to high cost of raw materials.
Since the company is buying raw materials for its production from different countries like Japan, etc. therefore the companyâ€™s expenses are in foreign currency and for which it is subjected to exchange rate fluctuations, which will determine the operating exposure to BMW.
Moreover, its operations are in almost all of the major countries around the world where its sales subsidiaries are located. The revenue generated from these countries in currencies such as Japanese Yen, US dollars, etc. are then converted into euros as a base currency. These transactions give rise to transaction exposure where the transactions are exposed to exchange rate risks.
In order to evaluate these exposures, the complete analysis of transactions related to sales and manufacturing operations need to be considered. Although the sales are high enough to cover the high costs of the company but still the deterioration of foreign currency ratios are exerting pressure on the financial results of the company.
BMWâ€™s hedging strategy
The current hedging strategy of BMW is more like natural hedging strategy. Considering the current hedging strategy in detail.
Firstly, it uses natural hedging through which the company tries to match the currency of its operating revenues with its operating expenses in order to cancel out any exchange rate effects to some extent. Company has issued instructions and risk figures for its global network, while all of its local treasury centers were to review the exposure on weekly basis which is then evaluated at the central treasury department.
Secondly, BMW uses an internally developed model, which it used to plan foreign exchange hedging. This model shows that an equilibrium rate, for all major currencies that BMW deals with, indicating their over or undervaluation. The model mainly focused on long-term hedges usually for six years. The difference between the equilibrium rate and spot rate are then evaluated for evaluating the exposure.
When the rate falls below the equilibrium range i.e. 1.15 US$/â‚¬ to 1.17 US$/â‚¬, the company then uses forward contracts in order to hedge, while in case of favorable rates the currency hedges are made to short term.
Apart from this, company also produces a 100% hedge by using two options consisting of long and short, by which it produces non-zero option, so it incurred no expense in using them. For example, company receiving the premium on one sold instrument and on other hand had to pay premium on bought instrument, as a consequence the premium cancels out the cost leaving the company neither better off nor worse off.
Furthermore, the company also uses â€˜cascade strategyâ€™ in order to hedge foreign currency. In which the initial coverage was less that 100% of the estimates while for the actual subsequent business years the coverage ratio began to fall. This is therefore used to evaluate the varying amount of hedging in different periods.
Some of the strategies seem to be good because using options enable the organization to take advantage of the upside gains from the transaction while hedging against the downward. In addition to this, it also avoids the premium cost through using two sided options. However, the internally generated model used was not appropriate due to operations and changing of exchange rates of related economies.
Appropriateness of Equilibrium Exchange Rate
Â Â Â The range of equilibrium exchange rate as used by BMW as a part of its currency hedging strategy, that is, 1.15 US$/â‚¬ to 1.17 US$/â‚¬ might be appropriate in relation to shorter term expectations of the exchange rates. But for the longer run the range might become unsuitable for BMW to be used as the equilibrium rate used for conversions of currency into euros.
The reasons for the inappropriateness of the equilibrium exchange rate range for its long-term usage are possibly the fact that economies are exposed to rapid changes in relation to changes in government policies of the economy. For example, the determinants that mainly causes the exchange rate to be changed are usually based on the effects resulting from the government policies such as, interest rates, tax rate, management of balance of payments account, national treasury, etc. and change in any of these can impact the value of the currency leading to changes in exchange rates……………………..
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