Read the attached mini-case on Merck and answer the following questions:

a. What are the main reasons that Merck decides to hedge its foreign exchange rate risk?

b. What hedging instruments did Merck consider and finally which instrument was used by the company. Why?

c. Is there any possible reason why Merck hedges only a portion of its foreign exchange rate risk?

d. How may hedging increase cash flows?

Exchange Risk Management at Merck3

To examine how companies actualiy manage exchange risk exposure, we choose Merck & Co. lncorporaled, a rnajor U-S. pharmaceutical company, and study its approrrch to overall exchange expcsure nlanagernent. While Merck's actual hedging decision reflects ils own particular business situation, the basic framework for dealing wiith currency exposure can be infomative for.other firms.

Merck & Co. primarilv develops, produces, and markets health care pharmaceuticals.

As a multinational company that operates in more than 100 countries.Merck had worldwide sales of $6.6 bilion in 1989, and it controllred about a 4.7% market share worldvvide. Merck's maior foreign competitors are European fims and emerging. Japanese firrns. Merck is among the most internationaliy orienled U.S. pharrmaceutical companies, with overseas assets accounting for about 40 percent of the firms total and with roughly 50 percetrt of its sales overseas.

As is typical in the pharmaceutical industry', Merck established overseas subsidiaries. These subsidiaries nurnber about 70 and are responsible for finishing imported products and rnarketing in the iocal markets of incorporation. Saies are denominated in local currencies, and thus the company is dlirectly affected by exchange rate fluctuations- Costs are incurred partly in the U.S. dollar for basic manulacturing and research and partly in terms of local currency for finishing, rnarketing, dislribution, and so on- Merck found that costs and revenues were not matched in individual currencies mainlv because of the concentration of research, rnanufacturing, and headquarters operations in the United States.

To reduce the currency mismatch, Merck first considered the possibility of redeploying resources in order to shift dollar cost-s to other currencies. The company, however; decided that relocating employees and manufucturing and research sites was not a practical and cost-effective way of dealing with exchange exposure. Having decided that operational hedging was not appropriate, Merck considered the alternative of financial hedging. Merck developed a five-step procedure for financial hedging:

1 . Exchange forecasting.

2. Assessing strategic plan impact.

3. Hedgine rationale.

4. Financial instruments.

5. Hedging program.

Step l: Exchange forecasting

Tiie first step involves reviewing the likelihood of adverse exchange rnovements. The treasury staff estimates possible ranges for dollar strength or weakness over the fiveyear planning horizon. ln doing so, the major factors expected to influence exchange rates. such as lhe U.S. tracle deficit, capital llows, tlre U.S. budget deflcit, and government policies regarding exchange rates. are considered. Outside forecasters are also polled on the outlook for the dollar over lhe planning horizon.

Step 2: Assesslng Strateglc Plan lmpact

Once the future excharnge rate ranges are estimated, cash flows and earnings are projecied and compared under the alternative exchange rate scenarios, such as strong dollar and weak dollar. These projections are made on a five-year cumulative basis rather than on a year-to-year basis because cumulative results provide more useful information concerning the magnitude of exchange exposure associated with the company's long-range plan.

Step 3: Deciding Whether to hedge

ln deciding whelher to hedge exchange exposure, Merck focused on the obiective of maximiizing long-terrn cash flows and on the potential eFfect of exchange rate movements on the firm's ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholder wealth.

Merck decided to hedge for two main reasons.

First, the company has a large portion ol'earnings generated overseas while a disprop, tianate share of cosls is incurred in dollars. Second, volatile cash flows can adverseiy affect the firm's abllily to implement the strategic plan, esperciaily investnrents in R&D that form the basis for future growth. To succeed in a highly competitive industry. the cornpany needs to make a long-term commitrnent to a high levrel of research funding. But the cash fflow uncertainty caused by volatile exchange rates makes it difficult to justify a high level of research spending- Managernent decided to hedge in order to reduce the potenlial effect of volatile exchange rates on future cash flows.

Step 4: Selecting the Hedging lnstruments

The objective was to select the most cost-effective hedging tool that. accomodated the company's risk preference, Among various hedging tools, such as forward currency contracts, foreign currency borrowing, and cur"rency options, Merck chose currency options because it was not willing to forgo the potential gains if the dollar depreciated against foreign currencies as it has bee tt doing against major currencies since the mideighties, Merck regarded option costs as premiums for the insurance policy designed to preserve its ability to implement the strategic plan

Step ,5: Constructing a Hedging Pmgram

Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price clf the currency options, and the percentage of income to be covered. Afler simulating the outcomes of alternative implernentation strategies under various exchange rate scenarios, Merck decided to ( I )hedge for a multiyear period using long-dated options contracts, rather than hedge year'by-year, to protect the firm's strategic cash flows, (2) not use far out-of-money options to save costs, and [5) hedge only on a partial basis, with the remainder self-insured. To help formulate the most cost-effective tredging program, Merck developed a computer-based model that stimulates the effectiveness of various hedging strategies. an example of simulation results, coparing distributions of hedged and unhedged cash flows. Obviously, the hedged cash flow distribution has a higher mean and a lower standard deviation than the unhedged cash flow distribution.

cash flows if a reduced risk lowers ihe firm's cost of capital and tax liabilities. ln this scenario, hedging is preferred to no hedging.