CASE WESTERN RESERVE UNIVERSITY

BMW: Currency Hedging 2007

Group Homework No.3
OPMT 476 10/19/2011

Ahmed Aldow, Rose Jemmy Demgne, Emily Super, Mithu Majumder

OPMT 476 Fall 2011

Group Assignment 3: Mithu, Ahmed, Emily, Rose

EXECUTIVE SUMMARY

In its hedging strategy, BMW uses its own estimate of a fair currency rate and compares it to the current market rate. Their horizon is six years and by using future contracts and options of three years, they try to cover their exposure gradually over this period. Their objective is to get at least 50% coverage, with priority given to contracts with closer maturity date. The remaining contracts will be used to cover the incoming months. Also, because of their double side approach with options, they do not benefit any increase in the stock price on the long term. A better approach will be to shorten the horizon to 3 years, adopt a one side option approach in order to get benefits from an increase in the market rate. When determining the equilibrium rate our group looked at the supply and demand of the US dollar based on lower interest rates, declining GDP, and the growing account deficit. Even with the weakening of the dollar it was determined that BMWs anticipated equilibrium rate range of 1.15 US$/ to 1.17 US$/ was very close to the actual equilibrium range if not slightly higher. This also indicated that the spot price of the exchange rate was high and the Euro was significantly overvalued. BMW has successfully exploited operational hedging with an aim to manage the sensitivities in cost and revenue in addition to offsetting the exchange rate risks while managing the competitive positions. For example, BMW operates and produces in all five continents. This global scale of supply chain network optimization addresses exchange rate risks along with other factors such as cycle time, transportation costs, custom duties, taxes, insurance and financing costs. These factors enabled the company to be resilient and flexible in its sourcing, production and logistics networks which led BMW to make optimal decisions to reduce or eliminate the effect of currency exchange fluctuation. Stock valuation of any firm relies on many factors. One of the very important factors is the profits that the company announces each quarter or at the end of its fiscal year. For multinational companies, profits will be affected by the exchange rates of the currencies where this company operates. Additionally, the relation between exchange rates fluctuations and stock valuation rely upon various factors such as the companys ratio of the net foreign revenues and its entire revenues. Higher cost of capital and higher material prices could be other consequences of currency fluctuations which could negatively impact the revenues and thus stock valuation of multinational companies such as BMW. BMWS HEDGING STRATEGY In its hedging strategy, BMW estimates internally the exchange equilibrium rate ($/) at which six year maturity future contracts and options are bought. In order to balance its operating expenses with its operations revenues, BMW bought long and short term options. Each month, the equilibrium rate is compared to the market rate. The amount of exposure is dependent on the time period and the difference in rates is reviewed monthly whereas exposures are reported weekly by every treasury center. By using natural hedging, BMW is trying to achieve at least 50% hedge over the contract period.

OPMT 476 Fall 2011

In practice, the strategy is as follows:

Group Assignment 3: Mithu, Ahmed, Emily, Rose

If market rate < equilibrium rate (weakening Dollar), BMW will hedge its exposure in the long term If current rate > estimate rate, hedging will be on the short term

This strategy only benefits BMW if the spot rate remains stable and is close to the equilibrium. It is not viable on the long term due to high volatility in currency. Another strategy would be to adopt a local hedging strategy. Each treasury profit center is responsible of its evaluating its own exposure and report it to the central office in Munich which role is to provide guidelines. It allows more reactivity and better accuracy. Also, the long-term exposure should be reduced to 3 years instead of 6 and BMW should only adopt a long hedge strategy as well as cover 100% of the estimated exposure for each business year. In fact, the two-sided strategies cost more in the sense that if the market rate is above the fair rate, not only do the losses account for the current year but also, they affect the protection of incoming business year. In addition to hedging US currency we would also recommend that BMW consider hedging for other currencies and raw materials. The next largest markets after Europe and the US are Asia and the United Kingdom (see case study exhibit 1B). Because a considerable amount of business is done in these areas it is recommended that BMW consider hedging to help minimize the effect of currency fluctuations on their profit margins (see case study exhibit 6). This is especially true for a country like Japan where the currency is correlated to the US dollar and therefore fluctuates rapidly with respect to the Euro. The UKs pound typically fluctuates similarly to the Euro, and would therefore not need to be hedged, however in the past year this has started to change as the pound strengthened and the UK raised interest rates.1 As a result the pound appreciated with respect to other currencies, including the Euro. This introduced a small margin of currency risk, which BMW could mitigate with hedging. As far as raw materials, the price continues to escalate (see case study exhibit 4). Where it is possible, BMW should look at hedging their raw materials to mitigate the risk due to the increasing costs. This is especially true for when it comes to crude oil and steel (available in some regions starting 4/28/20082). EQUILIBRIUM EXCHANGE RATE Since the Euros formation in 1999 the exchange rate between the US dollar and the Euro has fluctuated a great deal. After the initial weakening of the Euro in 2000 and 2001, where the exchange rate dropped into the low 0.80s US$/, the Euro started to rebound significantly in 2002. Ever since then it has continued to gain strength against the dollar at an average rate of approximately 10% per year. At the
Pound reaches 26-year dollar high, BBC News, 18 April 2007, 18 October 2011, <news.bbc.co.uk/2/hi/business/6566715.stm>. LME confirms 28 April 2008 as launch date for steel billet futures contracts, London Metal Exchange, 10 September 2007, 18 October 2011, < www.lme.com/media_resources/5214.asp>.
1 2

OPMT 476 Fall 2011

Group Assignment 3: Mithu, Ahmed, Emily, Rose

time of this case the spot price of the US Dollar to Euro exchange rate was fluctuating around 1.50 US$/; much higher than the calculated BMW equilibrium rate. Additionally, it appeared that the US dollar would stay weak in the future due to depreciation, lower interest rates, anemic growth and an increasing account deficit. Because of the significant weakening of the dollar over the past few years, the high spot price, and the expectations that the dollar would continue to stay weak, our group initially assumed that BMWs equilibrium rate was too low. Just like the price of goods and services, the equilibrium exchange rate for currencies that are free floating and therefore determined by the market (e.g. the US dollar and Euro) are based on the economic principles of supply and demand. In the case of currency the supply and demand is based on that of foreign goods and services, which are purchased using foreign currency, as well as the foreign currency itself. Factors such as interest rates, GDP, depreciation and foreign reserves all play a part in determining the equilibrium rate. By the end of 2007 and beginning of 2008 it appeared that the US had entered a recession caused by the sub-prime mortgage crisis. In an attempt to combat the impending recession the Fed kept their interest rates low, even lowering them further at some points, with hopes of increasing the demand for US dollars. While on the other hand, both the Bank of England and the European Central Bank only slightly adjusted their interest rates. Simultaneously economists were predicting that the GDP of the US would decrease in the coming year due to the recession. This was mainly because of the decreased consumer spending, rising debt and increased unemployment rates. The decrease in GDP and foreign spending by the United States would ultimately cause the demand for US currency to decrease. Our group decided that depending on magnitude, the increases and decreases in demand due to lower interest rates and declining GDP respectively had the potential to offset one another with regards to the equilibrium exchange rate. When reading the BMW article our group thought the largest indicator of supply versus demand for US currency was made apparent by the increase in the account deficit. Between 2000 and 2004 the amount of available US currency was increased, of which a large majority was purchased by Asian countries, presumably countries whose currency was pegged to the US dollar in an attempt to maintain the competitiveness of their own currency and exports. It was also important to note that the European countries did not react in a similar way to the Asian central banks, ultimately causing the European currency to appreciate with respect to the dollar. We assumed that because the supply and demand seemed balanced during this time period, the situation would be similar in the event of another increase in supply. This meant that the equilibrium exchange rate for the US dollar was still somewhat near BMWs anticipated equilibrium rate of 1.15 US$/ to 1.17 US$/. If this was the case then the difference in the

OPMT 476 Fall 2011

Group Assignment 3: Mithu, Ahmed, Emily, Rose

equilibrium rate and spot price would indicate that the price of the Euro was overvalued considerably at the time. As a light-hearted way to verify our assumptions our group looked at the Economists Big Mac Index for 2007 for the implied purchasing power parity (PPP). The Economist estimated that the implied PPP of the Euro was 1.12 US$/, compared to the spot price of 1.36 US$/. This calculated out to a 22% overvaluation of the Euro against the US dollar.3 The Big Mac Index for 2008 had an even larger overvaluation of the Euro at 50% because the actual exchange rate was 1.59 US$/ and the implied PPP was 1.06 US$/.4 Therefore our group was able to verify our assumptions and determine that the current equilibrium rate should be near BMWs original anticipated equilibrium rate if not a little lower. OPERATIONAL HEDGING AND THE US DOLLAR EXPOSURE BMW has relied very heavily on operational hedging with an objective to manage the sensitivities in cost and revenue as well as to offset the exchange rate risks while managing the competitive positions. BMW has strategically put together a global operational capabilities through its presence in different currency zones in different continents it has production plants, plants producing parts and assembly plants in North America (USA), South America (Brazil), Asia (China & India, Thailand, Indonesia and Malaysia), Great Britain, Europe (Germany, Austria), Africa (South Africa, Egypt) and Russia. BMW also has different business strategies in its repertoire starting from different brands (BMW, Rolls-Royce and MINI), different products (auto mobiles, motorcycles etc.), different models (3 series, 5 series, etc.) and different segments (automobiles, financials, etc). This global scale of supply chain network optimization addresses exchange rate risks along with other factors such as cycle time, transportation costs, custom duties, taxes, insurance and financing costs. All of these have made BMW very resilient and have created flexibility in their sourcing, production and logistics networks enabling them optimal decision making in the face of exchange rate fluctuations. BMW is also planning to increase the capacity of its US operating plant in South Carolina to reduce its net dollar exposure. (US revenue of $11.5 billion against its current operating cost in US of $3.5 billion creating a net dollar exposure of ~ $7.4 billion). With more emphasis on local procurement and local production, the exchange rate risk of operational cost will be minimized. The only part that will be exposed to currency fluctuation will be the profit margin. With increased flexibility in sourcing, production and logistics network, BMW could respond to demand dynamics in an efficient way.

3 4

The Big Mac Index: Sizzling, The Economist. 5 July 2007, 10 October 2011, <www.economist.com/node/9448015>. The Big Mac Index: Sandwiched, The Economist. 24 July 2008, 10 October 2011, <www.economist.com/node/11793125>.

OPMT 476 Fall 2011

Group Assignment 3: Mithu, Ahmed, Emily, Rose

BMWS PROFITS AND STOCK VALUATION

Currency fluctuation has very important implications on the profits and the stock valuation of companies that are multinational. As stated in the case, BMWs revenues increased by 14.3% to 56,018 million Euro, but they would have increased by an extra 17.6% if we didnt consider the weight of the exchange rate. The stock valuation of any firm depends on many factors. One of the very important factors is the profits that the company announces each quarter or at the end of its fiscal year. If this company happens to be a multination one, then its profits will be affected by the exchange rates of the currencies where this company operates. Moreover, huge fluctuations in these exchange rates could have a very profound impact on the companys profit and thus its stock valuation. The relation between exchange rates fluctuations and stock valuation rely upon various factors such as the companys ratio of the net foreign revenues and its entire revenues. For example, exhibit one in the case reveals that large chunk of BMWs revenues is generated in North America and therefore the ratio of the net foreign revenues to the total revenues by BMW is high which could cause big impact on the stock valuation of BMW. A strong Euro could have negative impact on BMWs revenue and thus its stock valuation. In the event that the Euro appreciated against the Dollar, US customers will find it very expensive to buy cars made in the Euro Zone. The decline in sales will consequently reduce the revenues generated in the US. One solution for BMW is to reduce its profit margin on cars manufactured in Germany and sold in the US but this action will again shrink the total revenues for BMW. Therefore, BMW decided to expand its production in the US to meet the high demand by its American customers. Another side effect of unfavorable exchange rates and volatile currency fluctuation is the risk of higher cost of capital for multinational companies which makes it very costly to invest in foreign countries and therefore these multinational companies might run the risk of losing market share to local companies if they dont undertake these investments. Increase in raw materials prices is another possible outcome due to fluctuation in currency exchange rates. If prices of raw materials, which are procured from outside Germany, go up, then BMW will have to adjust its prices by charging its customers higher prices which could lead them to look for other alternatives or cheaper alternatives provided by BMWs competitors. The loss of those customers is also a loss in revenue and therefore a potential loss in the value of BMWs stocks. In the 1990s Porsche tried to increase its prices to compensate for a weaker exchange rate but this strategy fired back and they almost lost their American franchise. Ironically, exchange rates can lead to extreme consequences. For example, a study shows that if the Euro had appreciated so much against the dollar, it will be cheaper for Germans to buy German cars from the US and had them shipped to be used in Germany. In this extreme scenario, BMW could lose its revenues made from local sales to less revenues made in the US.