iffany & Company

Tiffany has decided to sell direct in Japan as opposed to selling wholesale to Mitsukoshi and Mitsukoshi selling to the public. In this agreement Tiffany will give Mitsukoshi 27% of net retail sales in exchange for providing the boutique facilities, sales staff, collection of receivables, and security for store inventory. This new agreement exposes Tiffany to the fluctuation in the yen-dollar exchange rate. Therefore, they are considering two basic hedging alternatives to reduce exchange-rate risk on their yen cash flows. The first alternative was to sell yen for dollars at a predetermined price in the future using a forward contract. The second alternative was to purchase a yen put option allowing them to exercise their option only if it was more profitable in the future at the future spot rate. Two more alternatives that we think are appropriate are a synthetic forward using options and a synthetic forward using interest rate parity. Furthermore, Tiffany needs to understand the hedging alternatives and determine what, if any, strategy is right for them.

1.In what ways is Tiffany exposed to exchange-rate risk subsequent to its new distribution agreement with Mitsikoshi? How serious are these risks?

Tiffany is exposed to foreign exchange risk by selling directly to the Japanese market. When they sold wholesale to Mitsukoshi, Mitsukoshi bore all the foreign exchange risk. Under this new agreement Tiffany is now exposed to the volatile fluctuations in the yen-dollar exchange rate. Since Tiffany is making profits in yen they have to convert the yen to dollars to take back to their home country. Since the yen is thought to be overvalued in comparison to the dollar, the future exchange rate can decrease Tiffany's profits. Also, the extreme volatility in the exchange rate creates significant uncertainty in what the future exchange rate and profits will be if left unhedged. The most important foreign exchange risk facing Tiffany is the operating exposure risk. The other types of foreign exchange risk to be taken into consideration in order of importance are transaction and translation risk. Operating exposure - is created by changes in the amount of future operating cash flows caused by an exchange rate change. This is the most important source of future exchange risks and is difficult to hedge. Exchange gains or losses are determined by changes in the firm's future competitive position and are real. This risk impacts revenues and the costs associated with future sales and should be looked at long term. Therefore, Tiffany is exposed to this risk; if the yen depreciates against the dollar, Tiffany's will receive fewer dollars. Transaction exposure - results from existing contracts that are binding future foreign currencydenominated cash flows and creates a risk to the net present value of the contracts. Tiffany is exposed to this risk because they have agreed to reverse $115 million in sales. Only $52.5 million in inventory was repurchased from Mitsukoshi in July 1993. Mitsukoshi agreed to accept a deferred

payment of $25 million to be paid in yen quarterly over the next 4.5 years. The remaining inventory will be repurchased throughout February 1998. Translation risk - is created by changes in income statement items and book value of assets and liabilities caused by changes in the exchange rate. This risk relates to past activities which already appear on the balance sheet and income statement, therefore this type of risk is not serious because it does not affect Tiffany's distribution agreement with Mitsukoshi.

2.Should Tiffany actively manage its yen-dollar exchange rate risk? Why or why not?

Tiffany should actively manage its yen-dollar exchange risk. Tiffany knows they will have a substantial amount of yen cash inflows from their new arrangement of selling direct in Japan. If Tiffany does not hedge this currency exchange risk then their earnings will fluctuate. With the yendollar exchange rate being so volatile at this time (even having large changes from month to month), it is the best time to hedge in order to help smooth their earnings and reduce risk. The downside is that options prices are more expensive when there is more volatility. Since the yen is thought to be overvalued there is speculation that it will depreciate in the future compared to the dollar. If the yen depreciates and Tiffany converts their yen at the prevailing spot rate then their dollars received will be decreased.

3.If Tiffany were to manage exchange rate risk activity, what should be the objectives of such a program? Specifically, what exposure should be actively managed? How much of these exposures should be covered, and for how long?

The objectives of managing exchange rate risk should not be to bet on currency fluctuations or to try to make a profit on exchange rates. Instead the objective should be to reduce risk associated with operating exposure. By hedging, Tiffany can reduce drastic fluctuates in net income due to currency exchange rate changes. Smoothing net income can help with taxes by keeping cash flows smooth instead of having huge profits followed by a loss. The main objective of managing exchange rate risk should be to decrease volatility and reduce risk. Tiffany should actively manage operational exposure and transaction exposure. The longer exposures are covered the more expensive the option is; therefore Tiffany should hedge short term and then roll their position forward. Since Tiffany has to repay for inventory returned by Mitsukoshi on a quarterly basis they can use their cash flows in yen to repay Mitsukoshi and hedge only the remaining amount. Since the repayment is done on a quarterly basis Tiffany should buy a synthetic forward for three months to match their yen liability. This way, as the economy and outlook for sales changes, Tiffany can adjust their hedging strategy on a quarterly basis and hedge that amount minus their inventory repayment to Mitsukoshi.

4.As instruments for risk management, what are the chief differences of foreign exchange options and forward or future contracts? What are the advantages and disadvantages of each? What, if either, of these instruments would be most appropriate for Tiffany to use if it chose to manage exchange rate risk?

With foreign exchange options you pay the price up front and at expiration you have the option to exercise. If you buy a call option and at expiration it is in the money you will exercise your option and buy at the strike price. On the other hand, if the call is out of the money you will buy in the market place. This means you are not locked in to buying at a set price, but if favorable you have the option to do so. This is beneficial if you are uncertain you will need to hedge (uncertain cash flow or bid on a contract that you might not get) or if you want to keep the upside potential and do not want to lock into a specific rate. A forward contract is usually cheaper and it locks in the exchange rate to be made at a future date. The downside to a forward contract is that once you enter into it you have to deliver at expiration. This removes downside risk because you are guaranteed that exchange rate, but it also takes away upside potential because you have to deliver at the specified rate. Another alternative would be to create a synthetic forward using options by buying a put and selling a call with the same strike price. This would essentially lock in the future rate at the strike price, the cost of this would be the cost of buying the put minus the money you receive for selling the call (by selling the call you are lowering the cost compared to only buying a put). The last alternative would be to use a synthetic forward using interest rate parity and the given interest rates for the two countries. Tiffany should use the synthetic forward created by buying a put and selling a call to lock in the highest known dollar amount (the amount is known because they do not have to wait to see what happens to the spot rate at the time of exercise).

Summary of Options

June 1993 One Month Three Months Forward $ $ 10,342,720 30,917,897

Put if exercised

$ $

11,222,201 34,417,645

Synthetic Forward using Options $ $ 11,530,638 35,146,083

Synthetic Forward using Interest Rates $ $ 10,343,729 30,913,644

Unhedged estimate $ $ 10,289,623 30,876,126

** Unhedged using forward rate as an estimate of future spot rate

5.How should Tiffany organize itself to manage its exchange rate risk? Who should be responsible for executing its hedge? Who should have oversight responsibility for this activity? What controls should be put in place?

Tiffany should organize itself to have the treasury department manage their exchange rate risk. Since Tiffany has operations in other countries they might be over hedging by each location managing their own exchange risk when there might be natural hedges between currencies. Since there is no information given that Tiffany has a central department to hedge all of its exchange rate risk we are assuming that each location currently hedges its own risk. If this is the case the CFO should be responsible for having oversight of managing exchange rate risk, but an accounting department should be responsible for tracking the profitability of these transactions. The optimal idea would be to have a central location responsible for managing exchange rate risk, such as the treasury department. This would reduce costs and reduce the amount of hedging required. Controls should be in place to ensure that the person responsible for hedging exchange rate risk does not have oversight over all aspects of the transaction accounting for and monitoring the outcome. Such controls should include division of duties for accounting for profits of such strategies and the person implementing the strategies. This would provide checks and balances to ensure that unnecessary or risky hedging (misuse of authority) would not take place.