Discussion Question

Provide separate answers for each question. Do not delete the questions.

1. Volkswagen's Hedging Strategy

• Why did Volkswagen suffer a 95% drop in its 4th quarter, 2003 profits?

• Do you think the Volkswagen's decision to hedge only 30% of its anticipated U.S. saleswas a good? Why or why not?

• Do you think the Volkswagen's decision to revert back to hedging 70% of its foreign currency exposure was a good decision? Why or why not?

2. Embraer and the Wild Ride of the Brazilian Real

• Is a decline in value of the real against the U.S. dollar good or bad for Embraer? Why?

• What kind of foreign exchange rate risks is Embraer exposed to?

• How can Embraer reduce these risks?

• Do you think Embraer's decision to hedge against further appreciation of the real in the early 2000s was a good decision?Why or why not?

• Since 2008 Embraer has significantly reduced its dollar hedging operations. Is this wise?Why or why not?

3. Subaru's Sales Boom Thanks to the Weaker Yen

• Why has Subaru concentrated its manufacturing in Japan?

• What was the impact of the depreciation of the yen on Subaru's profits since 2012?

• Why is Subaru increasing its US production? Do you think it is a good decision? Why or why not?

4. Overall discussion

• What did you learn from these stories about hedging foreign exchange rate risk?

Volkswagen's Hedging Strategy

In January 2004, Volkswagen, Europe's largest carmaker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen's operating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention-the sharp rise in the value of the euro against the dollar during 2003 and Volkswagen's decision to hedge only 30 percent of its foreign currency exposure, as opposed to the 70 percent it had traditionally hedged. In total, currency losses due to the dollar's rise are estimated to have reduced Volkswagen's operating profits by some €1.2 billion ($1.5 billion).

The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had recorded a volatile trading history against the U.S. dollar. In early 1999, the exchange rate stood at €1 = $1.17, but by October 2000 it had slumped to €1 = $0.83. Although it recovered, reaching parity of €1 = $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar during 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003, the exchange rate stood at €1 = $1.25. For Volkswagen, which made cars in Germany and exported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To understand what happened, consider a Volkswagen Jetta built in Germany for export to the United States.

Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign exchange market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 = €1 (a forward contract gives the holder the right to exchange one currency for another at some point in the future at a predetermined exchange rate). Called hedging, the financial strategy of buying forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to exchange the dollars it got from selling Jettas in the United States into euros at $1 = €1, irrespective of what the actual exchange rate was at that time. In 2003, such a strategy would have been good for Volkswagen. However, hedging is not without its costs. For one thing, if the euro had declined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive because foreign exchange dealers will charge a high commission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 through forward contracts, rather than the 70 percent it had historically hedged. The decision cost the company more than €1 billion. For 2004, the company reverted back to hedging 70 percent of its foreign currency exposure.

Sources: Mark Landler, "As Exchange Rates Swing, Car Makers Try to Duck," The New York Times, January 17, 2004, pp. B1, B4; N. Boudette, "Volkswagen Posts 95% Drop in Net," The Wall Street Journal, February 19, 2004, p. A3; "Volkswagen's Financial Mechanic," Corporate Finance, June 2003, p. 1.

Embraer and the Wild Ride of the Brazilian Real

For many years Brazil was a country battered by persistently high inflation. As a result the value of its currency, the real, depreciated steadily against the U.S. dollar. This changed in the early 2000s when the Brazilian government was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by August 2008, 1 real bought $0.65, an appreciation of more than 100 percent.

The appreciation of the real against the dollar was a mixed bag for Embraer, the world's largest manufacturer of regional jets of up to 110 seats and one of Brazil's most prominent industrial companies. Embraer purchases many of the parts that go into its jets, including the engines and electronics, from U.S. manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals, which benefited Embraer's profit margins. However, the company also prices its aircraft in U.S. dollars, as do all manufacturers in the global market for commercial jet aircraft. So, as the real appreciated against the dollar, Embraer's dollar revenues were compressed when exchanged back into reals.

To try and deal with the impact of currency appreciation on its revenues, in the mid-2000s Embraer started to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder the right to exchange one currency-in this case dollars-for another-in this case reals-at some point in the future at a predetermined exchange rate). If the real had continued to appreciate, this would have been a great strategy for Embraer because the company could have locked in the rate at which sales made in dollars were exchanged back into reals. Unfortunately for Embraer, as the global financial crisis unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by almost 40 percent against the dollar. But for the hedging, this depreciation would have actually increased Embraer's revenues in reals. Embraer, however, had locked itself into a much higher real/dollar exchange rate, and the company was forced to take a $121 million loss on what was essentially a bad currency bet.

Since the shock of 2008, Embraer has cut back on currency hedging, and most of its dollar sales and purchases are not hedged. This makes Embraer's sales revenues very sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more appreciating against the U.S. dollar, which pressured Embraer's revenues. By 2012, however, the Brazilian economy was stagnating, while inflation was starting to increase again. This led to a sustained fall in the value of the real, which fell from 1 real = $0.644 in July 2011 to 1 real = $0.40 by January 2014, a depreciation of 38 percent. What was bad for the Brazilian currency, however, was good for Embraer, whose stock price surged to the highest price since February 2008 on speculation that the decline on the real would lead to a boost in Embraer's revenues when expressed in reals.

Sources: D. Godoy, "Embraer Rallies as Brazilian Currency Weakens," Bloomberg, May 31, 2013; K. Kroll, "Embraer Fourth Quarter Profits Plunge 44% on Currency Woes," Cleveland.com, March 27, 2009; "A Fall from Grace: Brazil's Mediocre Economy," The Economist, June 8, 2013; "Brazil's Economy: The Deterioration," The Economist, December 7, 2013.

Subaru's Sales Boom Thanks to the Weaker Yen

For the Japanese carmaker Subaru a sharp fall in the value of yen against the U.S. dollar has turned a problem-the lack of U.S. production-into an unexpected sales boom. Subaru, which is a niche player in the global auto industry, has long bucked the trend among its Japanese rivals of establishing significant manufacturing facilities in the North American market. Instead, the company has chosen to concentrate most of its manufacturing in Japan in order to achieve economies of scale at its home plants, exporting its production to the United States. Subaru still makes 80 percent of its vehicles at home, compared with 21 percent for Honda.

Back in 2012 this strategy was viewed as something of a liability. In those days, 1 U.S. dollar bought only 80 Japanese yen. The strong yen meant that Subaru cars were being priced out of the U.S. market. Japanese companies like Honda and Toyota, which had substantial production in the United States, gained business at Subaru's expense. But from 2012 onward, with Japan mired in recession and consumer prices falling, the country's central bank repeatedly cut interest rates in an attempt to stimulate the economy. As interest rates fell in Japan, investors moved money out of the country, selling yen and buying the U.S. dollar. They used those dollars to invest in U.S. stocks and bonds where they anticipated a greater return. As a consequence, the price of yen in terms of dollars fell. By October 2014, 1 dollar bought 115 yen, representing a 43 percent fall in the value of the yen since 2012.

For Subaru, the depreciation in the value of the yen has given it a pricing advantage and driven a sales boom. Demand for Subaru cars in the United States has been so strong that the automaker has been struggling to keep up. The profits of Subaru's parent company, Fuji Heavy Industries, have surged. In February 2015, Fuji announced that it would earn record operating profits of around ¥410 billion ($3.5 billion) for the financial year ending March 2015. Subaru's profit margin has increased to 14.4 percent, compared with 5.6 percent for Honda, a company that is heavily dependent on U.S. production.

Despite its current pricing advantage, Subaru is still moving to increase its U.S. production. It plans to expand its sole plant in the United States, in Indiana, by March 2017, with a goal of making 310,000 cars a year, up from 200,000 currently. When asked why it is doing this, Subaru's management note that the yen will not stay weak against the dollar forever, and it is wise to expand local production as a hedge against future increases in the value of the yen.

Sources: Chang-Ran Kim, "Subaru-maker, Fuji Heavy Lifts Profit View on Rosy US Sales, Weak Yen," Reuters, February 3, 2015; Yoko Kubota, "Why Subaru's Profit Is Surging," The Wall Street Journal, November 14, 2014; Doron Levin, "Subaru Profit Soaring on Weaker Yen," Market Watch, November 15, 2014.