Obviously, firms enjoy expanding their market share, but with international profits come and element of risk that must be taken into consideration. Foreign exchange rates and variances can cause serious issues for firms involved in international markets. Thankfully, firms can engage in hedging strategies to create systems that mitigate this risk. Allayannis and Weston (2001) found that hedging using financial derivatives increased firm value by an average of around 5% for non-financial firms based in United States, so it appears that there is a strong business case for hedging, beyond just managing risk appropriately.
Jin and Jorion (2006), elaborate on this research with reference to oil and Gas firms, but find that it varies from industry to industry. For our analysis, we wanted to focus on major players in the personal electronic industry and compare and contrast their hedging strategies in detail. In particular, we focused on Apple Inc. , Sony Corporation, HTC Corporation and Nokia Corporation. These selected firms gave us flexibility in our analysis. They compete for a similar market, yet all report financial details in different currencies, deal with different suppliers, and have different strategies in the markets.
With these differences in mind, we were still expecting to come across similarities that offer some insight about successful hedging strategies in this competitive industry. Research methodology and hypothesis Our main research method was to examine data from the external financial statements of the selected firms, where information regarding hedging strategies, foreign exchange gains or losses and other relevant information is found. We also thought it was important to look for peer reviewed research on the topic, so where applicable we included that in our report.
Additionally, we found it beneficial to examine data about individual foreign exchange markets that would be relevant for the individual company. This gave us several avenues with which to compare the companies, and generate solid conclusions about our findings. Going into the report, we thought that in general, the four chosen companies would use hedging to lock in future costs and revenues using a combination of forward and option contracts. They would clearly state how this mitigated their risk and discuss important decision.
We developed the following hypothesis that we would test over the course of our research and base our discussions around: Firms will use extensive hedging to mitigate cash flows and reduce foreign exchange exposure, including a wide variety of contracts and lengths of term specific to industry needs. Hedging for MNE’s Hedging is a risk management strategy used in limiting or offsetting probability or loss from fluctuations in the prices of commodities, currencies, or securities. Hedging includes swaps, options, and forward contracts and is used in a variety of different ways.
There are two kinds of general hedges in the market: fair value hedging and cash flow hedging. Fair value hedging is managing the risk to changes in fair value of a recognized asset or liability, or a previously unrecognized firm’s commitment to buy or sell an asset at a fixed price. Cash flow hedging on the other hand is management of the exposure to variability in cash flow that is attributable to a particular risk associate with a recognized asset or liability or a highly probable forecast transaction. Cash flow hedging can be used to deal with the inflow and outflow of different currencies firms will receive in the future.
MNEs usually adopt appropriate hedging strategy to match the cash flow with different currencies from international market. For example, in a recent year, IBM employed derivative instruments to hedge the volatility in stockholders’ equity resulting from changes in currency exchange rates of significant foreign subsidiaries of the company with respect to the U. S. dollar (“IBM Corp. ” 2008). The derivative instruments of IBM include options and forward contract, and IBM applied different policies based on the different situation of global market like changing the length of the derivative instruments.
In 2007, the weighted-average remaining maturity of all derivative instruments was approximately 1. 5 years while it’s changed to 2. 4 years in 2008. Hedging gives MNEs more opportunities to achieve their goals. It can help the company reduce market risk, and avoid excess risk with volatile currency variation. In addition, hedging can also be used to generate extra value and lock in the cost, which allows MNEs to avoid huge losses when there are big shocks that happen in the foreign exchange markets.
Personal Electronic Industry We chose this industry based on two criteria. Firstly, the special characteristics of the consumer electronic industry urges the companies to lower the costs, which may give rise to higher potential in using hedging strategies than other standard or slow life cycles industries. Secondly, fierce competition and high globalization exposure cause higher potential risks for the companies, which also increases the companies’ intention to reduce the uncertainty.
For our research, we considered the consumer electronics industry to be a global industry with a small number of highly competitive global players. It is a very fast moving industry with short product life cycles. Common products include cell phones, music players, personal computers, audio equipment, televisions, calculators, GPS automotive electronics, digital cameras and so on. Increasingly these products have become based on digital technologies, and have largely merged with the computer industry. This industry has high sales, high turnover and encourages a lot of change.
According to Schaller (1997) “Moore’s law” will continue to have powerful effects in the industry as processor speeds, or overall processing power of computers will double every two years. This indicates that the market is less predictable in the long term, and gives rise to firms’ using possible hedging strategies to reduce the uncertainty. Furthermore, it creates barriers to entry due to issues such as patents and economics of scale. According to BBC news (2007), the trend of falling price of the consumer electronic products has become one of the most important features in this industry.
It is the result of decreased labor costs as manufacturing has moved to lower-wage countries, increased manufacturing efficiency and automation, and improvements in semiconductor design. While consumer electronics continues in its trend of convergence, combining elements of many products, consumers face different decisions when purchasing. There is an ever-increasing need to keep product information updated and comparable, for the consumer to make an informed choice. Style, price, specification and performance are all relevant. There is a gradual shift towards e-commerce web-storefronts.
According ManMahon and Lee (2007) “the industry faces consumers with unpredictable consumer preferences on the demand side, supplier-related delays or disruptions on the supply side, and production challenges in the middle. The high rate of technology evolution or revolution requires large investments without any guarantee of proportional returns. ” As a result, the leading players are global companies that require global markets to achieve economies of scale. It is truly global with Asia Pacific having 35 percent market share, Europe having 31. percent, the US having 23 percent, and the rest of the world having the rest (Data Monitor 2004). The globalization character also indicates that the companies will more or less expose to foreign currencies, when they deal with suppliers in other countries or consumers outside the home country. Accordingly, other potential risks include the exchange rate fluctuations and possible global recession. Industry Examination Apple All data taken from the 2011 Apple Annual Report (“Apple Corp. ” 2012). Apple derives a significant portion of its revenue and earnings from its international operations.
Therefore, weakening of foreign currencies relative to the U. S. dollar will adversely affect the U. S. dollar value of the company’s foreign currency-denominated sales and earnings, and generally will lead them to raise international pricing, potentially reducing demand for products. Apple engages in hedging practices to mitigate certain exposures to fluctuations in foreign currency exchange rates and to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries.
The company may enter into foreign currency forward and option contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities. Apple’s general practice is to hedge a majority of its material foreign exchange exposures, typically for up to six months. Apple uses foreign currency forward and option contracts as their hedging tools.
To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates and partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies.
They also hedges to help protect gross margins from fluctuations in foreign currency exchange rates particularly with subsidiaries exposed to the US Dollar. This is important, as all financial details are reported in USD for the firm. Apple had a net deferred gain associated with cash flow hedges of approximately $290 million and a net deferred loss associated with cash flow hedges of approximately $252 million, net of taxes, recorded in 2011 and 2010, respectively. For a full outline of the gross fair value of Apple’s derivative positions, please see the Appendix.
In their financial statements, Apple claims that the use of such hedging activities may not offset more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. Thus there are some drawbacks the company recognizes. HTC All data taken from the 2011 HTC Annual Report (“HTC Corp. ” 2012). HTC uses financial derivatives to reduce any adverse effect of exchange rate fluctuations of account receivables/payables. Http’s management monitors and managing foreign exchange movements to significantly reduce adverse exchange rate effects.
As a multinational entity, HTC faces exposure similar to the rest of the industry where fluctuations in the more used currencies as USD will have a great impact of their business. HTC is a Taiwanese company with its subsidiaries in Europe and North America. Their revenues are dominated in USD and EUR and its manufacturing costs are primarily in US dollars. Thus, foreign exchange fluctuations have serious implications on the company’s revenues, operating profits and costs. By using financial derivatives as forward exchange contracts HTC are able to minimize this risk.
Judging by the size of the financial derivatives used it seems that they are hedging a great portion of their cash flows. For example, HTC’s total value of financial derivatives in 2011 were as follows; EUR of 339 million, GDP 17. 1 million, CNH 671. 7 million and CAD 28. 9 million. HTC manages these contracts on a short-term basis and avoid contracts designed with longer terms. Looking at their financial statements, their holdings of forwards consists primarily of 1-3 month contracts. During 2011, the company needed to make active capital risk management decisions.
The Euro depreciated against the NT dollar from 1:39 to 1:42 but returned later that year to the initial value. Also the US dollar fluctuated and ended up appreciated to the NT dollar after the year. Under effective management the company was able to keep the net income positive and earned approximately NT $174 million as a result. You can compare this with the 2010 and 2009 net result in the appendix, which we believe indicates proficiency in hedging by the firm. Nokia All data taken from the 2011 Nokia Annual Report (“Nokia Corp. ” 2012).
Nokia uses foreign currency hedging with the purpose of lowering expenses and specifically offsetting the appreciation of the Euro against certain currencies. Foreign currency hedging is not without risks, but Nokia is aware of them and actively monitors them. It was stated in Nokia’s annual report that the gross margin might be negatively affected by unfavorable foreign currency hedging. There are several factors that affect Nokia’s decision for foreign exchange exposure such as foreign currency dominated assets and liabilities, highly probable purchase and sale commitments, as well as translation from non-Euro into Euro.
Accordingly, Nokia hedges four types of exposures including forecasted cash flows – typically with a 6-12 month hedging horizon, – material transaction exposures, balance sheet exposures and selected net investment exposures. Nokia uses different hedging strategies to mitigate the uncertainty of foreign exchange. The most common ones are forward foreign exchange contracts and currency options, however, interest rate and currency swaps are used also and valued by analyzing discounted cash flow.
Besides foreign currency hedges, Nokia also focuses on fair values of cash settles equity derivatives. Cash flow hedges or operating hedges are defined by the company as: the hedging of anticipated foreign currency denominated sales and purchases. “Qualifying hedges” are those properly documented cash flow hedges of the foreign exchange rate risk of future anticipated foreign currency denominated sales and purchases that meet the requirements of financial reporting. Hedging of foreign currency risk of highly probable for business acquisitions and other transactions.
Nokia hedges the cash flow variability due to foreign currency risk identified in likely business acquisitions and other future transactions that result in the recognition of non-financial assets. It should also be noted that Nokia applies fair value hedge accounting with the objective to reduce the exposure to fluctuations in the fair value of interest-bearing liabilities due to changes in interest rates and foreign exchange rates. An effective strategy that was unique in our findings Sony All data taken from the 2011 Sony Annual Report (“Sony Corp. ” 2012).
Over the past two decades, the JPY/USD has been one of the most volatile currency pairings in the world (Reszat, 1998). This has created a myriad of obstacles for international Japanese firms, and Sony has had to weather this risk. Sony’s volatile FX gain/loss patterns over the past three years could be a result of this inherent volatility, but we believe it is a sign of less strict hedging policies. According to Salvatore (1993), Sony has historically been apposed to foreign exchange hedging, but recognizes it as a necessary practice in its highly competitive industry.
As such, Sony follows some common themes already discussed. It uses relative short term hedging devices for its consumer electronics businesses. The derivative portfolio Sony constructs is made up of options and forwards with contract lengths around 3-6 months. One interesting strategy Sony explicitly mentions to reduce foreign exchange risk is to localize production where products are sold, or to create production facilities in nations with relatively stable financial structures compared to the targeted markets (example: Canada and the United States). 2007 financial statements) This allows Sony to centralize costs and shift focus onto positive cash flows generated by subsidiaries, rather than funding costs. It means that many localized costs can be dealt with at the micro level (subsidiary) rather than the macro level (corporate office). Beyond this, Sony is relatively sparse about its hedging strategies, however we have made some inferences based on information from the statements. Which is consistent with our findings.
Sony appears to be the least interested in direct financial hedging of the four examined firms, and that point is emphasized in its financial statements. Summary of Findings We have looked into the consumer electronics market with a focus on four different firms, operating all over the world. Our companies are chosen because of their structure, but also for the accessibility of information provided These companies are different in terms of cultural background and basic structure and different target markets worldwide.
Our findings are mainly on an industry wide level, where we are investigating similarities and differences within the industry as a whole. If we start by looking at the overall strategies within this group of companies there is clear evidence of patterns. All of the companies are mainly using options and forwards, with an exception for Nokia who uses currency swaps in certain situations where they deem it would be advantageous. (Nokia, 2012). They are all hedging a greater part of its prospected cash flows and overall costs and it is all done within a time range within a year.
Our findings also show that these four companies have made profit out of their hedging (short term), even though the size is varying among our players. This could be attributed to the view of hedging in each of the firms. For HTC and Nokia, it appears hedging is a huge part of their business model, but with Sony – less so. Focusing on the risk and the purpose of hedging the companies are also similar in their purpose/reasons for hedging. They are all commenting on their spread of operations, exposing them to the three different risks: transactional, transnational and economical.
An example would be in Apple’s financial statement, where it is said that they need to protect themselves from foreign exchange risk associated with assets and liabilities, future committed transactions, forecasted cash flows and their net investments into foreign subsidiaries. Looking at these findings more in details makes this much more interesting. First of all, why are these companies using financial derivatives on such short time period? Some of the characteristics of the consumer electronic industry are the fast movement and development, small barriers of entry and foremost the short product life cycles and its price ensitivity of its customers. All these qualities make it hard for the companies to forecast its cash flows, the main criteria and base for their hedging. Without the ability to forecast in a longer time range it make sense to focusing on a narrower time range. The usage of long-term derivatives would, depending on the type of derivative be, either costly or expose the firm to the risk of greater fluctuations in the FOREX market. (Apple, 2012) Our findings show that all the companies are using financial derivatives, After all, when engaging in a hedge, a financial transaction – it is at its best a zero net present value project?
So why are these used? Looking further back in the net of hedging in these companies it makes it clear that they are not constantly making profit from this. Thus, hedging brings another variable to the equation by questioning whether it is within shareholder’s best interests. In terms of firm value, hedging has still not been proven to be of a benefit in compare with a firm that does not hedge Conclusion and final comments Overall, it appears that firms are hedging for the better. They are able to make more accurate forecasts and base decisions off of those.
Since solid decision-making is at the forefront of all business decisions, hedging makes sense, particularly in risky industry such as the one examined. Moving forward, as our global economy continues to evolve and change, proper understanding of foreign exchange risk will become an increasingly larger part of a firm’s responsibility. Without hedging, this risk becomes difficult to manage, thus proper understanding of hedging principles should e an important focus not just in the personal electronics industry but for any multinational enterprise.
As firms continually realize this, inventive new ways to hedge may arise and a source of competitive advantage could result from hedging expertise. With increasing global forces moving firms towards globalized mindsets, those with the strongest understanding of global market structures and risks will likely be able to differentiate themselves. Therefore, it is critical for firms in any industry to understand hedging and make it an active part of their risk management structure.