1.In what way(s) is Tiffany exposed to exchange-rate risk subsequent to its new distribution agreement with Mitsukoshi? How serious are these risks? 2.Should Tiffany actively manage its yen-dollar exchange rate risk? Why or why not? 3.If Tiffany were to manage exchange rate risk activity, what should be the objectives of such a program? Specifically, what exposures should be actively managed? How much of these exposures should be covered, and for how long? 4.As instruments for risk management, what are the chief differences of foreign exchange options and forwards or futures contracts? What are the advantages and disadvantages of each? Which, if either, of these types of instruments would be most appropriate for Tiffany to use if it chose to manage the exchange-rate risk?
Question 1: In what way(s) is Tiffany exposed to exchange-rate risk subsequent to its new distribution agreement with Mitsukoshi? How serious are these risks?
Exchange rate risk relates to the effect of unexpected exchange rate changes on the value of the firm. Tiffany & Company are exposed to exchange-rate risk subsequent to its new distribution arrangement with Mitsukoshi due to the fluctuating exchange rate. Yen is usually more volatile and tends to fluctuate in the same direction as the dollar. Yen is also overvalued and could depreciate resulting in lost profits. These risks are fairly serious because they can decrease both profit margin and the value of assets of the company. Not protecting themselves against this exchange rate risk will hurt the company’s sales, bottom line, and top line; therefore it is extremely important that Tiffany realizes these risks.
Question 2: Should Tiffany actively manage its yen-dollar exchange rate risk? Why or why not?
Yes, Tiffany should actively manage its yen-dollar exchange rate risk and hedge against this risk because if they did not they would be taking on too much risk. It is very important in terms for reducing a firm’s vulnerabilities from major exchange rate movements, which could adversely affect profit margins and the value of assets. Also, not hedging against this exchange rate risk allows for being exposed to transaction risk and economic risk.
Transaction risk is the exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time difference between the entrance and settlement of the contract, the greater the transaction risk due to the fact that there is more time for the two exchange rates to fluctuate. Economic risk is the risk that the firm’s present value of future operating cash flows will be affected from exchange rate movements. Not hedging against the overall exchange rate risk will negatively impact Tiffany & Company profit margins and lead to exposure or other various types of risk.
Question 3: If Tiffany were to manage exchange rate risk activity, what should be the objectives of such a program? Specifically, what exposures should be actively managed? How much of these exposures should be covered, and for how long?
To manage exchange rate risk activity, Tiffany’s objectives should be to minimize foreign exchange rate risk and lower counterparty risks. We want to minimize these risks because Tiffany & Co. is selling goods that are denominated in US dollars, but sold for yen in the Japanese market. The objective of this program is to prevent the depreciation of the yen against the US dollar by hedging the currency. The expected Japanese sales of Tiffany & Co. should be actively managed by purchasing hedging contracts continuously on expiration of previous contract.