Tiffany & Co. was founded in 1837 in New York City by Charles Lewis Tiffany and John B. Young. After decades of development, the company has grown to an internationally famous designer and retailer of fine jewelry, diamonds, timepieces and other luxury accessories. In July 1993, Tiffany made a decision to directly operate sales in Japan, rather than profiting from medium corporation Mitsukoshi. According to this decision, Tiffany will pay Mitsukoshi 27% of net retail sales for providing the local services and bearing the risk of holding inventories. Below is a snap shot of the financial summary of Tiffany & Co from 1988 to 1993. The total revenues grew sustainably over the past years before the decision. However, for the cash flow statements, the company had been losing profits in terms of investments.
The new decision put Tiffany to a very difficult situation where the firm will face the fluctuation of the yen-dollar exchange rates. Due to the fact that the yen is considered to be overvalued with regards to the dollar, the uncertainty of future rates will diminish the company’s profits. In addition, Tiffany also keeps the company exposed to the volatility of the future exchange rate and related risks remain unhedged.
As a result, the management came up with two-pillar strategy – to sell yen for dollars at a preset price in the future with a forward contract and to buy a yen put option with the flexibility to excise in the future with a more favorable price. The first strategy is to get a short position in a forward contact, which sells yen to the counterparty at a pre-decided price in the future. Tiffany and the counterparty of the contact both have the obligations to honor the agreement until the contract is expired. The second strategy will allow Tiffany the right, but not the obligation to sell yen at a pre-decided price in the future.
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After this new agreement with Mitsukoshi, Tiffany & Co are exposed to significant exchange risk. 75 of 492 million US dollar total revenue will be settled in terms of Japanese yen. This counted for approximately 15% of the revenue of 1992. The net income would also suffer from the exposure of foreign currency exchange rate. The number of 1992 is 25 million US dollar. According to the case, there is high possibility that 10% of fluctuation would be reasonable, which may potentially cause a down fall of roughly 20 million US dollars loss. There will be no doubt that Tiffany should proactively manage its yen-dollar exchange risk. Investors value companies which will provide a solid solution for offshore business risk management.
The company may just lose portion of revenues in the beginning. However, if the issue remains lacking sufficient attention, it will eventually have negative influence on the core business revenues. Customers will start to question the company’s brand equity. Investors would doubt the continuing profit-generating capacities of the equity. These facts will cause much stronger fluctuation and more severe fundamental problems. In terms of the risk management objectives, each firm will vary because of different risk appetite. In the industry, analysts will run VaR test based on certain scenario and yield various possible results. The management should analyze on the risk within a scale which tailors to the company’s specific needs. In my own opinion, company should aim at hedging the exchange rate risk instead of gaining extra profits from the derivatives market.
Exchange Rate Risk." Exchange rates are the amount of one country's currency needed to purchase one unit of another currency (Brealey 1999, p. 625) ." People wanting to exchange some money for their vacation trip will not be too much bothered with shifts if the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of ...
From the below screen shot of yen/dollar exchange rate from 1989 to 1993, we can conclude the rate will be rather volatile and unpredictable. Additionally, there was market assumption that the yen was overvalued in terms of dollar. Therefore, it would be natural to consider the possibility of the yen crashing. Thus, a yen put option seems to be a more favorable strategy for Tiffany.