BMW: Currency Hedging 2007 Case Solution

1. How would you evaluate BMWs transaction and operating exposure?

Transaction exposure basically measures the extent to which financial obligations and commitments of the past are subject to the exchange rate risk. The greater the volatility of value of the financial contracts for the company in response to changes in exchange rates, the greater the transaction exposure for the company. Net transaction exposure for a company can only be estimated because there is no particular formula for calculation of the net transaction exposure. Transaction exposure directly affects the costs of raw materials purchased in currencies other than EURO. The values of financial commitments that the company makes in foreign currency change directly in response to currency fluctuation.

On the other hand, operational exposure measures the change in the value of the company due to change in future cash flows caused by currency rate fluctuations. In other words, this exposure measures the extent to which revenues and profitability are exposed to exchange rate risk. Operating exposure of BMW is much more significant that transaction exposure because a significant part of sales revenue is dominated in foreign currency and has to be converted into domestic currency. Operating exposure also measures the change in the competitive position of the company in response to change in the exchange rate. Although costs of new models launches for BMW increased significantly, the competitive position of the company did not change significantly due to high operational efficiency.

2. What do you think of BMWs hedging strategy?

As compared to its competitors, BMW is more affected by the exchange rate movements because the hedging strategy of the company was not very accurate and affective. BMW had 17 different production facilities in six different countries. Therefore, like all multinational companies, BMW was exposed to a huge exchange risk. The impact of macroeconomic events on BMW’s profitability was immense. Companies like BMW not only have to convert their sales in the foreign countries into home currency but also have to buy raw materials and other inputs of production from foreign countries. Therefore, change in exchange rates directly affects the profit margin of the multinational companies like BMW. There are three ways for the company to deal with the exchange rate movements. The first and most obvious is not doing any hedging at all. The underlying assumption behind this move is that currency fluctuations are very temporary and insignificant. Therefore, the benefits from hedging are not worth the high costs associated with hedging. The second option for BMW is to hedge fully and literally shield profitability of the company from the exchange rate movements completely. Although this idea seems very appealing because it significantly lowers the risk, it is at the same time a very expensive option. The third option for BMW is to actively manage hedging by closely watching currency rates movements and devising strategies in response to these movements. This is the option that BMW choose to shield it significant part of costs and revenues from currency rate movements. An equilibrium exchange set by the company serves as a bench mark that guides the mode of hedging to be selected by the company. A company like BMW has a lot of earnings at stake due to the exchange rate risk and at the same time has to bear huge costs for hedging; therefore, it is best for the company to do the cost benefit analysis and engage in active hedging.

3. Taking into account the evolution of the US$/EUR exchange rate during the last few years do you consider a range of 1.15 US$/EUR to 1.17 US$/EUR to be an appropriate equilibrium rate?

No, the range of equilibrium exchange rate devised by BMW’s model for prediction of exchange rate was not quite fair keeping in mind recent macroeconomic changes and events. Year 2007-2008 was marked with unexpected macroeconomic events and immense financial crisis. The model used by BMW failed to predict such a crisis and its impacts on the profitability of the company. This range of exchange rates served as a benchmark by BMW because if the exchange rate fell below this level, BMW would engage in the long term and large scale hedging. Otherwise, BMW will look currency hedging and will remain restricted to short term and small scale. The greatest shortcoming of this approach was that next year’s earnings of the company will remain highly volatile and dependent in US dollar spot rate. BMW should engage in more active hedging strategy rather than setting a strict benchmark because fluctuations in exchange rates were so great that a BMW had very little time to respond.

4. How would you define such an equilibrium exchange rate?

Equilibrium exchange rates are normally viewed in two ways by financial experts. Experts who believe that the exchange rate is determined by the demand and supply of a currency in the market believe that the market exchange rates are always at equilibrium. The market equilibrium is for short term and relies on fundamentals, which in turn depend on expectations for currency movements in the future. However, movements of exchange rate depend to a large extent on noise and speculative bubbles created in the market. Another way to predict the equilibrium exchange rate is by using Purchasing Power Parity. However, PPP has many practical limitations, and it so; it cannot be used for effectively predicting equilibrium exchange rate. Therefore, an effective way to predict the equilibrium exchange rate is by closely monitoring all macroeconomic events and using the average of exchange rates predicted by reliable financial institutions.