Toyota employed derivative financial instruments, including foreign exchange

forward contracts, foreign

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Foreign exchange risk Essay

Toyota Motor Corporation is the worlds third largest automaker. It was established in Japan on
28 August 1937. Apart from its 12 plants in Japan, Toyota has 54 manufacturing companies in 27
countries, employs 246700 people and markets vehicles in more than 160 countries. Its capital as
at March 2002 was 397 billion yen.
Toyota is exposed to the fluctuation in foreign currency exchange as it operates mainly in
America, Continental Europe and Britain. It is therefore affected by the fluctuation in the value
of the US dollar, the Euro and to a lesser extent the British
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pound. Toyotas consolidated financial statements, which are presented in the Japanese yen, are
affected by the foreign exchange fluctuation, as all the amounts in the various countries
currencies have to be translated into yen. Toyotas primary markets based on unit sales for
vehicles for financial year ended March 31 2002 were Japan (40%), North America (32%) and
Europe (13%). Toyota is listed on the London, New York and Tokyo stock exchanges.

In the normal course of doing business, Toyota employs derivatives financial instruments,
including forward contracts and foreign currency options to manage its exposure to fluctuation in
foreign currency exchange rates. Toyota does not use derivatives for speculation and trading.
(http://www.toyota.co.jp/en/ir.html accessed on 14th November 2002) The profitability of
Toyotas operations is affected by many factors including the changes in the value of the
Japanese yen against other currencies which Toyota does business. The financial year for Toyota
is from 1 April to 31 March.
IMPACT OF FOREIGN EXCHANGE RISK ON OPERATION
The value of the Japanese yen has fallen generally for the past three years against the dollar and
the
Euro
though
there
had
been
periods
of fluctuations.
(http://pacific.commerce.ubc.ca/xr/data.html accessed on 14th November 2002). Changes in
foreign exchange rate affect Toyotas revenue, gross margins, operating costs, operating income,
net income and retained earnings. Toyotas cost and liabilities are affected by transaction
exposure which relates primarily to sales proceed from Toyotas non domestic sales produced in
Japan. It is also affected to a lesser extent sales proceed from Toyotas continental Europe sales
produced in UK.
Toyotas use of forward exchange rate contracts and currency options is to hedge foreign
exchange risk associated with trade receivables denominated primarily in U.S. dollars. Toyota
also engages in foreign currency settlements with domestic counter parties. The company enters
into forward contracts and purchases currency options (principally euro and dollar) to hedge
certain portions of forecasted cash flows denominated in foreign currencies. Additionally, the
Company enters into forward exchange contracts to offset the earnings impact relating to
exchange rate fluctuations on certain monetary assets and liabilities. The Company enters into
forward exchange contracts as hedges of net investments in international operations. This
reduces foreign exchange risk and transaction costs in those settlements by handling receipts in
the foreign currencies in which they are denominated.
Toyota buys supplies from Peugeot in France and is therefore exposed to the Euro exchange rate.
It also manufactures engines in Japan for BMW. These inflows and outflows as a result of
dealing with these European companies expose Toyota to foreign exchange risks. Cars produced
in Japan and other production sites are shipped to Europe and America, which are the major
market for Toyota. Toyota has to make a decision as to which currency to price the cars. If the
cars are priced in yen in order to avoid foreign exchange risk, Toyota will not be competitive in
those markets, as it would have shifted the risk to its customers. If the price is in the domestic
currencies Toyota will be exposed to foreign exchange risk. When there is a depreciation or
appreciation of the currencies in relation to the yen, Toyota will be torn between changing the
price to reflect the change in the exchange rate.
This decision will depend on the price elasticity of demand for cars among other factors. Toyota
manages these risks by using forward contracts, money market hedging and option market
hedging. Toyota also enters into currency borrowing to address a portion of its transaction risk.
Foreign exchange forward contracts are used to limit exposure to losses, resulting from changes
in foreign currency exchange rates on accounts receivable and transactions denominated in

foreign currencies. Foreign exchange forward contracts, which are designated and effective as
hedges of currency, risk on existing assets and liabilities are included as an offset to foreign
exchange gain or loss and recorded on the existing assets and liabilities. Foreign currency option
is to reduce the risks that are likely to be incurred on account receivable and anticipated
transactions denominated in foreign currencies. This has reduced, but not eliminated, the effects
of foreign exchange fluctuation.
The preparation of Toyotas consolidated financial statements is in conformity with accounting
principles accepted in the United States of America. All assets and liabilities of foreign
subsidiaries are translated into Japanese yen at the appropriate year end current rates and all
income and expense accounts are translated at rates that approximate those prevailing at the time
of the transaction. Toyota therefore uses the temporal method of translation. The resulting
translation adjustments are included as a component of accumulated income. Toyota is exposed
to translation risk when the results of subsidiaries are translated into yen. The value in yen may
not reflect the true value of the subsidiary, as it will also depend on the exchange rate between
the two countries at the time of the translation.
This can distort significantly when results of different periods are being compared and among
various geographical markets. The yen has been stronger in fiscal year 2000 as against 1999.
According to Toyotas Annual Reports, net revenue increased by 6.1% in 1999 and decrease by
0.4% in 2000. If the difference in yen used for translation purposes are eliminated, net revenue
would have increased by 5.9% in 1999 and increased by 11.2% in 2000
(http://www.toyota.co.jp/en/ir.html accessed on 14th November 2002). Thus, even though the
consolidation figure showed a decrease in net revenue in 2000, it was mainly due to the
strengthening of the yen in 2000, which made dollar values smaller after translation.
The value of the yen against the Euro and the dollar fell generally for the past three years. The
fall of the yen for the past three years has made Toyota reported profit when it is translated into
yen though in actual fact it may not have been so. Toyotas net revenue for fiscal year 2002
showed a 9% increase over the previous year. This is because of the weakening yen and the
translation effect. If the difference in yen value used for translation purposes is eliminated,
Toyota showed only 2.8% increase. Net revenue increased by 15.5% in North America, 24.8% in
Europe and 0.4% in Japan, for fiscal 2002 compared to 2001 after consolidation.
If translation effect is eliminated, the net revenue in North America increases by only 2.2% and
12.9% in Europe (http://www.toyota.co.jp/en/ir.html accessed on 14th November 2002). There
was a double digit devaluation of the yen to the dollar in the business year ended March 31 2002.
Toyota gained 70 billion yen from favourable exchange rate. The US dollar rose to about 127 yen
from about 123 yen a year ago. A strong dollar helps the earning of Toyota by boosting the value
of overseas revenue when converted into yen. However, translation effect is a reporting
consideration and does not affect Toyotas underlying operation. Toyota does not hedge against
translation risk.
Toyota manages its operating exposure by diversifying its operation and financing. It has
localised much of its production by constructing production units in most of the countries in
which it operates. Local operation allows Toyota to purchase most of its supplies and resources

used in the production process in currencies that matches the currencies of local revenue with
local expenses. Toyota has asked its UK suppliers to settle all bills using Europes single
currency, the euro (http://news.bbc.co.uk/1/hi/business/873840.stm accessed on 16th November
2002). This reduces its exposure to changes in the value of the pound.
Toyota has diversify its finance base by being able to raise funds in more than one place and
thereby take advantage in interest rate differentials. Toyota can therefore borrow in Japan, United
States of America or Europe to take advantage of interest rate differentials. With the expected fall
in the American Interest rate as against the Japanese interest rate, Toyota can borrow in dollars so
as to take advantage of the fall in interest rates. The expected fall in American interest will lead
to a fall in the value of dollars in relation to the yen. This fall will make loans and other
commitments denominated in dollars less expensive in yen terms. Toyota will therefore gain
from the expected depreciation of the dollar.
The most obvious source or determinant of economic currency exposure comes from firms
having revenues or costs denominated in foreign currencies. These direct or transaction effects
are relatively easy to identify and manage. In addition, firms that also have foreign-based
operations will have translation exposures that arise from consolidation. At the same time, there
are also a number of indirect effects, which can be just as important and apply both to firms
engaged in international business and to domestic firms, but which are substantially more
difficult to recognise. This indirect economic currency exposure arises from unexpected
movements in foreign exchange rates changing the competitive situation of the firm and which
affect the firms future cash flows (and hence value).
GLOBAL ECONOMIC FORECAST
INFLATION DIFFERENTIALS
The exchange rate stated simply is the price of one currency in terms of another currency.
Exchange rate can therefore be expressed in terms of the law of one price which states that in
the presence of a competitive market structure and the absence of transportation cost and other
barriers to trade, identical products which are sold in different markets will sell at the same price
in terms of a common currency (Pilbeam, K. (1992) International Finance, Macmillan). Relative
purchasing power parity says that the change in the price level of commodities in one country
relative to the rate of change in price levels in another country determines the exchange rate
between the two countries. This in other words means that the rate of inflation in one country
relative to another determines the rate of change in their respective currencies. (Ross et al, 1999).
Thus if there is higher inflation in one country in relation to others, prices of goods and services
will increase in that country in relation with others and exchange rates have to change
accordingly in response to inflation differentials.
According to the World Economic Outlook of the International Monetary Fund
(http://www.imf.org/external/pubs/ft/weo/2002/02/pdf/appendix.pdf accessed on 14th November
2002), inflation is expected to move from -1.40% in 2002 to -1.2% in 2003 in Japan. This is
14.3% rise in inflation in Japan. Inflation in United States of America is expected to move from
1.2% in 2002 to 1.9% in 2003. American inflation is expected to increase by 58.3% whereas

inflation in the Euro area is expected to decrease by 17.4%. This means that prices of goods and
services in America will increase more than prices in Japan whiles prices in Europe is expected
to decrease.
The expected increase in the prices in America will lead to the depreciation of the dollar against
the yen in order to maintain the purchasing power parity. The relative decrease in the level of
inflation in Europe as against Japan will lead to the appreciation of the Euro against the yen. The
yen is therefore expected to appreciate against the dollar but depreciate against the Euro. This
will affect Toyotas revenues and profits, as whatever amount is translated from dollar to yen will
be lower comparatively. However, it will gain when the Euro is translated, as values will be
higher after translation.
BALANCE OF PAYMENT
Balance of Payment measures the flow of economic transactions between the residents of a given
country and the residents of other countries during a certain period of time. The use of balance of
payment data to forecast foreign exchange rates assumes a fixed exchange rate regime. The
balance of payment suggests that the current account get worse as national income rises. This is
because the increased income will lead to increased income will lead to increased demand for
goods and services including foreign products. This will lead to an increased demand for foreign
currencies and a decrease in the value of the domestic currency. The basic tendency is for
domestic currency to weaken to pay for the increased imports. In a fixed exchange regime, when
this falls below certain limits the domestic government will have to intervene by selling resaves
of foreign currencies in the foreign exchange market (Buckley, A. 2000).
The same is with surplus where instead of selling foreign currencies, the government will buy
foreign currencies. This will increase demand or supply of foreign currencies and therefore affect
the price i.e. the exchange rate. Thus if domestic income levels were to rise, the increase will
lead to transaction demand for money which means that if the money stock and interest rates are
held constant, the increased demand can only come about through a fall in domestic prices. The
fall in domestic prices will then requires a depreciation of the currency to maintain purchasing
power parity. However, an increase in foreign income levels leads to a fall in foreign prices level
and therefore a depreciation of the home currency to maintain purchasing power parity (Pilbeam
1993). If there is increased demand for Japanese goods and services by Americans and
Europeans then the yen is likely to appreciate, as the demand for yen will increase.
However, under a floating exchange system, the government has no responsibility to peg the
exchange rate. The fact that the overall balance does not sum to zero will automatically alter the
exchange rate in the direction necessary to obtain a Balance of Payment close to zero (Eitman et
al). If the country is running a substantial current account deficit whilst the capital and financial
account balance is zero, it will have a deficit Balance of Payment. There will be excess supply of
domestic currency and the market will rid itself of the imbalance by lowering the price through
the depreciation of the currency.
INTEREST RATE DIFFERNTIALS

The interest rate parity theorem implies that if interest rates are higher domestically than in a
particular foreign country, the foreign countrys currency will be selling at a premium in the
forward market; and if interest rates are lower domestically, the foreign currency will be selling
at a discount in the forward market (Ross et al 1999). The link between interest rate and
exchange rate is explained by the International Fisher Effect, which holds that the interest rate
differential is an unbiased predictor of future changes in the spot exchange rate (Rugman et al
2000). This differential is also important in determing forward exchange rates because this rate
would be that which neutralises the difference in interest rates between the two countries.
If the interest rate of one country is expected to fall in relation to another country, this will make
the demand for financial instruments denominated in that currency to fall. This fall in demand for
financial instruments will lead to a fall in demand of that currency and therefore a depreciation of
that currency. However, if interest rates are expected to rise in relation to other countries, there
will be an increase in demand for financial instruments denominated in that currency and an
appreciation of the currency. In practical terms, the international fisher effect implies that while
an investor in a low interest country can convert his funds into the currency of a high interest
country and get paid a higher rate, his gain (the interest rate differential) will be offset by the
expected loss because of foreign exchange rate changes.
The recent announcement of a fall in the American interest rate whilst the Japanese interest rate
remain constant will lead to a fall in the demand for dollar denominated instruments and
therefore a fall in the value of the dollar in relation to the yen. The Euro interest rate is not
expected to change and therefore the exchange rate between the yen and the Euro may not
change on the basis of interest rates.
RISK MANAGEMENT STRATEGIES
Toyota uses a value-at-risk analysis (VAR) to evaluate its exposure to changes in foreign
currency exchange rates. The value-at-risk of the combined foreign exchange position represents
a potential loss in pre-tax earnings that are estimated to be 25.2 billion as of March 31, 2001
and 24.0 billion as of March 31, 2002. Based on Toyotas overall currency exposure (including
derivative positions), the risk during the year ended March 31, 2002 to pre-tax cash flow from
currency movements was on average 25.0 billion, with a high of 26.7 billion and a low of
22.9 billion. The value-at-risk was estimated by using a variance/ covariance model and
assumed a 95% confidence level on the realization date and a 10-day holding period. Toyota
changed the model used for calculation of value-at-risk from variance/covariance method to
Monte Carlo Simulation method because Toyota introduced a new system, which Toyota
considers more effective for risk management purposes. The prior year amounts have been
restated to the fiscal 2002 presentation. (Toyota Annual Report 2002)
LEADING AND LAGGING. Larger, more centralized corporations have additional options that
may be employed to help control the foreign exchange risk of inter company transactions. One
effective and potentially profitable approach involves leading (prepaying) payments when the
payers currency is devaluing against the payment currency and lagging those payments if the
payers currency is appreciating. Lagging is when a company pays its financial commitments late
so as to take advantage of a devaluing currency. Leading on the other hand is paying early before

a currency devalues. It serves as a means of shifting liquidity between subsidiaries to avoid bid
ask spreads and take advantage of interest rate differentials (Clark E. et al 1993). Toyota should
take advantage of the fall in the interest rates in United States and subsequent expected fall in the
value of the dollar. The American subsidiary should pay early all monies owned to the parent
company in Japan.
This will give a higher value than waiting for the dollar to devalue before paying. From a
company wide standpoint, the treasurer can direct leading and lagging policy in order to take
advantage of the favourable effects of exchange rate fluctuations. Additionally, leading and
lagging policies may be used to shift funds from cash-rich to cash-poor affiliates, thereby
improving short-term liquidity. However, leading and lagging is only possibly when the company
has 100% ownership of the subsidiary. This is because the effect of an extended or reduced
payment date alters the relative rate of return of each subsidiary. This is unfair to minority
shareholders, as they do not necessarily benefit from such a practise that benefits the
multinational as a whole. (Eiteman et al 2001). Toyotas subsidiary in the US has minority
shareholders like General Motors and these will be at a disadvantage if Toyota should use
leading and lagging to manage its exposure. Inequality may arise unless the adjustment is made
to reflect a subsidiarys sacrifice.
NETTING. Netting inter company transfers is another form of international cash management
strategy that Toyota can employ. It requires a high degree of centralization. The basis of netting
is that, within a closed group of related companies, total payables will always equal total
receivables. Netting is useful primarily when a large number of separate foreign
exchange transaction occur between subsidiaries (Eiteman et al 2001). Thus instead of Toyota
paying monies owed to and by each subsidiary, the subsidiaries can net off each others debt and
thereby not deal in the foreign exchange market. In order to reduce the bank transaction cost,
such as spread between foreign exchange bid and ask quotations and transfer fees, Toyota should
establish an in house netting centre. The exposure that remainsnet payments to payeescan then
be hedged in the forward market if desired.
The advantages of netting are
A reduction in foreign exchange conversion fees and funds transfer fees as commissions on
foreign exchange transactions and funds transfer are drastically reduced.
A quicker settlement of obligations reducing the groups overall exposure.
REINVOICING. Reinvoicing goes one step beyond the centralized approach of multilateral
netting by way of a clearing centre. A reinvoicing centre buys goods from the manufacturing
subsidiary or parent, without taking possession, and reinvoices other company affiliates or third
parties when it sells the goods. By conducting all transactions in the affiliates functional
currency, the reinvoicing centre bears all currency risks. This prevents the FC exposures from
distorting the subsidiarys operating profit (loss). In addition, the reinvoicing centre allows for
centralized cash flow management, increase international business expertise and opportunities
for arbitrage. The centre also improves and centralizes banking relationships and acts as a central
purchasing agent for subsidiaries.

Most important, the reinvoicing centre can assess its net position on all inter company
transactions and hedge in the forward market accordingly. Problems with reinvoicing centres are
* Some countries prohibit reinvoicing centres, as well as any third-party billing (for example,
France, Spain,).
* They are very expensive to set up because sophisticated information systems and legal and tax
expertise are required.
BACK TO BACK LOANS
Back to back loans is when two firms arrange to borrow money in each others currency so as to
avoid the risk associated with exchange rate fluctuation. Toyota can enter into an agreement with
an American company that has a subsidiary in Japan. Toyota can then lend yen to the Japanese
subsidiary of the American company and the American company in turn lends Toyotas American
subsidiary money in dollars. This will reduce the risk that Toyota will have had if it had lend the
money to its American subsidiary as the expected fall in the value of the dollar will have reduced
the amount of yen to be received. The advantage with back to back loan is there will not be the
need to change currencies as loans will have been contracted in the functional currency of the
subsidiary and therefore there will be no risk. However it is very difficult to get a partner who
will be prepared to enter into such an arrangement.
NATURAL HEDGING
Natural hedging is to manage an anticipated exposure to a particular currency by acquiring a debt
denominated in that currency. Thus if a firm has a long term inflow in one currency, the firm can
acquire an outflow in the form of a loan in the same currency and use the inflow to service the
debt. Since Toyotas main markets are the USA and Europe, it can take out loans in Euro or
dollars and use the proceeds from its operations to pay for the loan. Toyota will then not have to
bother about the exchange rate fluctuation, as it will be paying the loan from proceeds generated
from local operations. Toyota is also asking its British suppliers to bill them in the Euro so as to
reduce the risk. This is effective in eliminating currency exposed when the exposure cash flow is
relatively constant and predictable over time (Eiteman et al 2001)
FORWARD CONTRACT
Forward contract is an agreement to exchange currencies of different countries at a specific
future date and at a specific forward rate (Eiteman et al 2001). If Toyota has receivables
denominated in US dollars in the form of loans owed to the parent company, it can enter into a
forward contract to hedge against the expected fall in the value of the dollar. When the value of
the dollar depreciates, Toyota will therefore not be at risk. However, should the predictions not
come true and the dollar rather appreciates, Toyota would have lost the opportunity of earning
more on the spot market.
REFERENCES

1. BUCKLEY, A. (2000) multinational finance. 4th ed., Harlow : Financial Times Prentice Hall.
2 CLARK, E. LEVASSEUR, M. ROUSSEAU, P. (1993) international finance, London :
Chapman and Hall.
3 PILBEAM, K. (1992) international finance, Basingstoke : Macmillan Education.
4 RUGMAN, A. M. (2000) international business: a strategic management approach, 2nd ed.,
Harlow: Financial Times/Prentice Hall.
5. EITEMAN, D.K., STONEHILL, A.I., MOFFETT, M. H. (2001) Multinational business
finance, 9th ed.,
6.ROSS, S.A., WESTERFIELD, R., JAFFE, J. (1999) corporate finance, 5th ed., London:
McGraw Hill.
6. (http://www.imf.org/external/pubs/ft/weo/2002/02/pdf/appendix.pdf accessed on 14th
November 2002),
7. (http://www.toyota.co.jp/en/ir.html accessed on 14th November 2002)
8. (http://pacific.commerce.ubc.ca/xr/data.html accessed on 14th November
2002)
9. (http://news.bbc.co.uk/1/hi/business/873840.stm accessed on 16th November 2002)

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