Unfavorable exchange rates may require a multinational company to decide between increasing prices and accepting a decline in income. This case study demonstrates how the German automaker BMW decreased their vulnerability to exchange rates.
Scott has worked as a professor in higher education for more than ten years. He has an M.Div. in Academic Biblical Studies, an MBA in Management, and an MA in counseling.
In This Article...
Abstract
BMW sells a sizable number of its vehicles to the rest of the world after producing the vast majority of them in Germany. The corporation thus runs a lot of foreign exchange risks. BMW controls the currency rate exposure with both natural and financial hedge mechanisms. BMW has two approaches in regards to natural hedging. “Production follows market” is the first strategy. BMW has manufacturing in the United States, Great Britain, China, and South Africa. Purchase after sales is the second tactic. The amount of US dollars that BMW spends on purchases and procurement has increased dramatically, particularly in the NAFTA zone. BMW purchases foreign exchange forwards and occasionally some straightforward option instruments as a form of financial hedging. The example can be utilized in risk management and international finance courses.
BMW’s foreign exchange risk management plan
When it first started, BMW used a home country production strategy. BMW moved its production facility from its home nation to the marketing countries due to greater transportation costs, currency rate risks, higher operating costs through labor costs, connected expenses with the raw materials, and product distribution. BMW opened a factory in the USA in 1992 to take advantage of cheaper operational expenses and lower transportation costs while avoiding exchange rate risks. It aided the business in gaining competitive edge in international markets. The cost of production is comparatively higher in the home nation. The client is required to pay the highest labor costs and social benefits in the entire world. The value of German currency relative to the USD is also unfavorable for BMW’s financial stability. In 1994, BMW opened a new production facility in Mexico to support the region’s marketing efforts. This made it easier for the business to take advantage of advantages like Mexico’s high-quality, low-cost labor force and prospective Latin American demand for passenger cars. The main drivers of BMW’s global production strategy are the elimination of currency concerns and the utilization of lower operational costs. BMW is better able to decrease its economic exposure thanks to the diversification of its production facilities across many nations. When real exchange rates in one country fall, it makes it easier to move output to a country with growing real exchange rates. BMW implemented its acquisition strategy in the UK by signing a $ 1.2 billion agreement with Rover, a British automaker. It enabled low-cost production capacity to be attained. It boosted the BMW’s capacity for production. The raw materials used in production are imported from Latin America, where the higher transportation expenses offset the reduced production costs and favorable exchange rates. BMW shortened its product development cycles from seven to three years in order to compete in the market. By using modern technologies in the production process, the variety of models and variations available is increased. The business was able to quickly adapt to the shifting customer demands thanks to it. BMW carries the luxury car brand image, and the acquisition of Rover enables BMW to diversify their product offers. Rover’s introduction enabled them to enter the market for affordable cars without harming BMW’s reputation. Local governments are implementing incentive programs to draw in foreign investors. BMW is better enabled by the state of South Carolina for moving its production facility there thanks to tax incentives and other benefits. n.d. (Cheol, McElreath, & Robert).
How do you manage the risk of exchange rates?
You might look for nations with strong, rising currencies if you’re trying to invest at the national level. In other words, these currencies are strong of comparison to the currency in your country. The investment will be worth more in your local currency if the exchange rate for the foreign currency rises further.
One location to search for investments is in nations with a history of prudent management and low debt to gross domestic product. High debt levels frequently result in high inflation, and high inflation can erode investors’ faith in the currency and cause it to decline.
What are the three most widely used exchange-rate risk strategies?
- Foreign exchange risk is the possibility that fluctuations in currency exchange rates will have an impact on a company’s financial situation or performance.
- Transaction risk, economic risk, and translation risk are the three categories of foreign exchange risk.
- For exporters, importers, and companies that conduct business in foreign markets, foreign exchange risk is a significant risk to take into account.
What kind of danger does foreign exchange rate present?
Exchange-rate risk is important because it influences how much money an investor actually sees at the end of the day, which in turn affects the investor’s rate of return.
Exchange-rate risk, however, might present opportunities because interest rates between two nations sometimes reflect anticipated changes in their exchange rates. For instance, the U.S. dollar will likely lose value in relation to the Canadian dollar if interest rates are higher in Canada. (This is due to foreign money moving into a country when interest rates rise to take advantage of the greater yields. As a result, the value of that nation’s currency rises.) Exchange-rate risk also allows holders of foreign bonds to participate tangentially in foreign exchange markets.
What dangers can fluctuating currency rates pose to a business?
- The risk that changes in the exchange rates between currencies will have an impact on a company’s operations and profitability is known as exchange rate risk.
- Currency fluctuation exposes businesses to three different categories of risk: transaction risk, translation risk, and economic or operational risk.
- By using operational methods and currency risk mitigation techniques, the risks associated with operating or economic exposure can be reduced.
- Exchange rate risk is a concern in the present globalized economy for small and medium-sized firms as well as multinational corporations and companies that conduct business overseas.
How do businesses protect themselves from exchange rate risk?
Companies that are exposed to international markets can frequently use currency swap forward contracts to manage their risk. Utilizing forward contracts, many funds and ETFs also hedging currency risk.
The buyer can fix the price they pay for a currency by entering into a currency forward contract, also known as a currency forward. To put it another way, the exchange rate is fixed for a specified amount of time. Every major currency is available for purchase with these contracts.
The contract safeguards the value of the portfolio in the event that exchange rates reduce the currency’s worth, preserving, for instance, a portfolio of stocks with a U.K. focus in the event that the value of the pound falls in relation to the dollar. On the other hand, if the value of the pound increases, the forward contract is unnecessary and the money spent to purchase it was a waste.
Therefore, purchasing forward contracts has a price. Funds that employ currency hedging think that the expense of hedging will eventually pay off. The fund’s goal is to lower currency risk while accepting the higher cost of purchasing a forward contract.
How can you control exchange risk when doing business abroad?
Foreign exchange (FX) risk is a necessary component of conducting business internationally. Major currencies’ exchange rates are continually fluctuating, which leaves your company’s income unclear. By securing future exchange rates, many businesses prefer to get rid of this uncertainty. However, some companies see fluctuations in currency rates as a financial opportunity.
Making and receiving payments entirely in your own currency is the simplest risk management technique for lowering foreign exchange risk. However, if clients who use various native currencies plan their payments to benefit from variations in exchange rates, your cash flow risk may increase. Additionally, your suppliers could be reluctant to take payments in what is to them a foreign currency and you might lose consumers to other businesses that provide greater currency flexibility. Therefore, you can discover that competitive forces compel you to investigate a risk management approach that aids in more effective control of your foreign exchange risk.
How are companies protected from changes in currency rates?
Forward Agreements A forward contract enables a business to guarantee a fixed exchange rate for future payments. This entails taking precautions against the volatility of the currency market.
What goals does exchange rate management seek to achieve?
Exchange controls are governmental limitations and controls placed on personal transactions made in foreign currencies. Exchange control is primarily used by the government to control or avert a negative balance of payments position on the national accounts. It entails directing all or a portion of the foreign cash that a nation receives into a communal pool that is managed by officials, usually the central bank.
Why do exchange rates fluctuate?
Exchange rates fluctuate frequently due to supply and demand. Whether one currency is more sought-after than another relies on how valuable people consider it to be when using it to make investments or pay for products and services.
What steps did BMW take to control its visibility in the US?
BMW was one of the first European automakers to move manufacturing towards the United States rather than away from it in the 1990s, demonstrating the success of its natural hedging strategies. BMW in particular began operations in Spartanburg, South Carolina. In 2008, this facility had a $750 million expansion. More than 5,000 jobs were added by the expansion alone in the US, whereas more than 8,100 jobs were lost in Germany. Moving the production and its employment to the United States lowered exchange exposure since BMW was able to buy and sell without having to exchange currencies because the country saw a much higher rate of auto sales than Germany did.
BMW used the same approach in China as well. The corporation worked hard to source local suppliers for the cars being constructed in the China location rather than looking at worldwide suppliers, where exposure is considerable. As a result of the proof of concept’s considerable success in China and the United States, BMW carried out further expansions of their natural hedging technique in India and Russia. Additionally, these expansions had some degree of success.
What methods are employed to reduce the risk of foreign exchange?
The use of hedging contracts via financial instruments is the trickiest, albeit possibly most well-known, method of reducing the risk associated with foreign exchange. Hedging can be done using either a forward contract or a currency option.
contracts for forward exchange. A business enters into a forward exchange contract when it decides to acquire or sell a particular quantity of foreign currency at a future date. The firm can safeguard itself from future variations in the exchange rate of a foreign currency by entering into this contract with a third party (usually a bank or other financial institution).
This contract’s goal is to protect against a loss on a specific transaction by hedging a foreign exchange position. In the prior example of the equipment transaction, the business can buy a foreign currency hedge that fixes the EUR/$ rate at 1.1 at the time of sale. The transaction fee to be paid to the third party and the adjustment to account for the difference in interest rates between the two currencies are included in the cost of the hedging. Hedging can often be done for up to 12 months in advance, while it is possible to hedge some of the most important currency pairs for longer periods of time.
In my professional experience, I have used forward contracts numerous times, and they can be very effective—but only if the business has reliable working capital procedures in place. Only if transactions (customer receipts or supplier payments) occur on the anticipated date will the protection’s advantages become apparent. To make sure this occurs, the cash collection/accounts payable teams and the Treasury department need to be closely aligned.
Optional currencies. The corporation is given the choice, but not the duty, to purchase or sell a particular currency at a particular rate on or before a particular date. Although they resemble forward contracts, the corporation is not obligated to complete the transaction by the time the contract expires. As a result, the investor would exercise the option and profit from the contract if the exchange rate of the option was better than the rate on the spot market at the time. The investor would let the option expire worthless and transact in foreign exchange on the spot market if the rate on the spot market was less advantageous. The corporation will be required to pay an option premium in order to access this flexibility.
Let’s say that in the aforementioned equipment scenario, the corporation would prefer to enter into an option rather than a forward contract, and that the option premium would be $5,000.
The corporation would execute the option in the event that the USD declined from EUR/$ 1.1 to $1.2, so avoiding the exchange loss of $10,000 (although it would still incur the option cost of $5,000).
The corporation would let the option expire and bank the exchange gain of $15,000, leaving a net gain of $10,000 after deducting the cost of the option, in the event that the USD strengthens from EUR/$ 1.1 to 0.95.
In actuality, the price of the option premium will vary according to the trading currencies and the duration of the option. Many businesses think the price is too high.