Question

BMW manufactures most of its cars in Germany but its sales are in the U.S., Eurozone and the UK, with the US being its largest market. Sales to the U.S. and UK are invoiced in US dollars and pound sterling, respectively. Its major competitors are based in the US, UK and Japan.

a. Explain the types of foreign currency exposure faced by BMW.

b. What is the likely impact on BMW’s profitability of an appreciation in the value of the US$?

c. If the value of the Euro were to fall relative to the US $ what advice would you give to BMW’s Foreign Exchange Risk Manager in relation to its hedging strategy

d. What non-derivative and non-financial strategies might BMW employ that would reduce its economic exposure on US and UK car sales?

Answer 1

Solution:-

(a)

The major types of foreign currency risks that BMW is exposed are the following:-

- BMW invests capital and incurr costs in Euros, thus the business needs to earn returns in terms of euros, hence biggest foreign currency risks that BMW faces are revenue risks wherein the convertible euro value of revenue earned in dollars and pounds may take a beating due to strengthening of euros against dollars and pounds. Since the customer contracts are in foreign currencies and it's revenue in dollars and pounds is fixed due to competitive forces, the company always needs to hedge this risk in particular through derivatives

- The next risk is the competition risk. The company has its competitors in US, UK and Japan. The company incurs cost in Euros and has to earn the profits in euros whereas competitors do so in in their respective currencies. Movement in exchange rates could possible give cost based competitive advantages to the competitors, which could enable them to lower their prices and take away market share from BMW.

For example if the Japanese yen goes down against dollar, it would increase profitability of Japanese car makers who incurs costs in yen but sells in US market. This would give them a competitive advantage such that they can lower their car prices to snatch market shares from BMW.

(b)

If the USD appreciates in value against dollar, it improves profitability of BMW as it earns it's revenue in dollars and a stronger dollar would mean higher convertible euro value of its revenue figure.

(c)

If the value of euro were to fall against dollar, it would be positive for the company since the company makes it sales in dollars in the US market and its convertible euro value of dollar sales would go up. So, from the perspective of hedging, the hedging manager only needs to ensure that the company hedges any payment it has to make in US dollars for any cost or investment related to its US operations.

For example if the company has to invest 100 million dollars in near term for buying an office in thanthe US, the manager takes a derivative hedge to protect forex loss when that future payment is made.

(d)

In addition to the derivatives based strategy that the company can employ to hedge it's forex risk, the following operational strategies are also available:

- Diversify it's sales globally so that the majority of revenue is not restricted to one country (US right now) and thus movement in one currency doesn't hamper the financials badly

- The company can contemplate setting up production in the US which would mean that the company would both incur cost and earn revenue in dollars, which means that any movement in foreign exchange rate would automatically offset itself to a large extent as foreign exchange losses to revenue would be offset by foreign exchange benefits to cost and vice-versa