International Finance Final Report

Dealing With Foreign Exchange Fluctuation: A Case Study on How BMW Deals
With Foreign Exchange Risks

This report is written by:

1935510103 Hind Oumalouke
1935510216 Jonathan Wijaya
1935510219 Edwin Thungari Macpal
Contents
Introduction................................................................................................. 3
Foreign Exchange Fluctuations....................................................................3
Foreign Exchange Hedge............................................................................. 4
How Does a Currency Hedge Work?.........................................................4
Methods to Mitigate Foreign Exchange Risk.............................................4
BMW Case: Dealing with Exchange Rate Risk.............................................5
Transaction’s risk and operating exposure...............................................5
BMW’s hedging strategy..........................................................................5
Conclusion................................................................................................... 6
References.................................................................................................. 7
Introduction
In 2019, the trading in foreign exchange markets worldwide accounts for $6.6
trillion per day. This indicates that foreign exchange is getting more and more
important year by year. The foreign exchange itself refers to the trading of different
national currencies or units of account. For most people, foreign exchange refers to
Forex or FX, which is a global marketplace where you can trade one currency for
another. Foreign exchange is a measurement that is monitored by every country, the
exchange rate of one country’s currency to the other depicts the nation’s economic
health and performance. It plays a significant role for a country to monitor its
economic health and performance. Because of that, in this report, we will go through
foreign exchange fluctuations, and foreign exchange hedge, then take a look at the
real case that BMW did to deal with foreign exchange fluctuations.

Foreign Exchange Fluctuations

At the basic level, foreign exchange depicts the price of goods or services that
are produced or located in a certain country. With this in mind, the exchange rate of a
country’s currency to the other is simply the ratio between the price level of the two
specific country. This reasoning is inline, with the economic theory of purchasing
power parity or the PPP which states that the exchange rate between two countries’
currencies equal to the ratio of the countries’ price levels. To achieve this equality or
simply equilibrium, therefore the exchange rate in the foreign exchange market of a
certain country, fluctuates or adjusts in accordance to the country’s general goods or
services’ prices. By definition, foreign exchange fluctuation could be defined as the
changes of a currency’s value against other currencies – commonly stated in terms of
US dollars, Japanese Yen, Chinese RMB Yuan, British Pound, and other major world
currencies – as a result of market forces or governmental policies that affect the
macroeconomic variables throughout the interlinked world economy.
Foreign exchange fluctuation can be caused by either market forces and
governmental policies. Market forces are impacts which are mainly caused by the
actions of individuals – sellers and buyers – that impact the supply and demand of a
currency. Toward individual holders, there are three main variables that are taken into
account when considering to hold a certain currency; they are the rate of return, which
is simply the profitability that one could get for holding the currency, second is risks
that is associated with the security or stability of the currency’s value overtime, and
last is liquidity that is the currency’s ease to be disposed to other form of asset. An
example of market forces would look something like the following, due to good
economic performance and profitability in the US, investors might move its monetary
assets from let’s say the Euro to USD, the likely implication would be that the USD
will appreciate in value since it has become highly demanded by the individuals while
the Euro would possibly depreciate in value against the US dollar. Another factor, that
is commonly associated with foreign exchange fluctuation is governmental policies
either through the central bank or its government itself. Central banks often intervene
in the foreign exchange market, through controlling the interest rates and the money
supply. Changes in the interest rate, affects various part of the economy such as
money demand and future expectations related to the currency, this in turn affect the
currency’s exchange rate. While change in the money supply, would also affect the
price level within a country and therefore affect its exchange rate value. These factors
are just a small portion of the whole picture, there are more variety of variables that
affect the exchange rate changes which makes it often unpredictable.
Due to its unpredictability, risks associated with foreign exchange fluctuations
are often costly when they are not managed accordingly. This cost could often be seen
from international investors and multinational companies that are operating with
multiple currencies. Therefore, managing the risk through financial instruments or
hedging should be the priority for these companies and investors to lower the risk and
loss that might occur throughout their international operations.

Foreign Exchange Hedge

A foreign exchange hedge (also called a FOREX hedge) is a method used by
companies to eliminate or "hedge" their foreign exchange risk resulting from
transactions in foreign currencies. This is done using either the cash flow hedge or the
fair value method. A forex hedge is a transaction implemented to protect an existing
or anticipated position from an unwanted move in exchange rates. Forex hedges are
used by a broad range of market participants, including investors, traders, and
businesses. By using a forex hedge properly, an individual who is long a foreign
currency pair or expecting to be in the future via a transaction can be protected from
downside risk. Alternatively, a trader or investor who is short a foreign currency pair
can protect against upside risk using a forex hedge.
How Does a Currency Hedge Work?
The easiest way to think about a currency hedge is like a form of insurance. It
is an instrument that helps protect against financial loss arising from movements in
exchange rates. It is an agreement to buy or sell currency at a predetermined exchange
rate at a specific date in the future.
Methods to Mitigate Foreign Exchange Risk
 Transact in Your Own Currency
Companies in a strong competitive position selling a product or service with
an exceptional brand may be able to transact in only one currency. For example, a US
company may be able to insist on invoicing and payment in USD even when
operating abroad. This passes the exchange risk onto the local customer/supplier.
 Build Protection into Your Commercial Relationships/Contracts
Many companies managing large infrastructure projects, such as those in the
oil and gas, energy, or mining industries are often subject to long-term contracts
which may involve a significant foreign currency element. These contracts may last
many years and the exchange rates at the time of agreeing to the contract and setting
the price may then fluctuate and jeopardize profitability.
 Natural Foreign Exchange Hedging
A natural foreign exchange hedge occurs when a company is able to match
revenues and costs in foreign currencies such that the net exposure is minimized or
eliminated. For example, a US company operating in Europe and generating Euro
income may look to source product from Europe for supply into its domestic US
business in order to utilize these Euros. This is an example which does somewhat
simplify the supply chain of most businesses, but I have seen this effectively used
when a company has entities across many countries.
 Hedging Arrangements via Financial Instruments
Hedging arrangements via Financial Instruments also known as formal
financial hedges. It contains two primary methods, they are:
o Forward exchange contracts: A forward exchange contract is an agreement
under which a business agrees to buy or sell a certain amount of foreign
currency on a specific future date. By entering into this contract with a third
party (typically a bank or other financial institution), the business can
protect itself from subsequent fluctuations in a foreign currency’s exchange
rate. The intent of this contract is to hedge a foreign exchange position in
order to avoid a loss on a specific transaction.
o Currency options: Currency options give the company the right, but not the
obligation, to buy or sell a currency at a specific rate on or before a specific
date. They are similar to forward contracts, but the company is not forced to
complete the transaction when the contract’s expiration date arrives.

BMW Case: Dealing with Exchange Rate Risk

As we all know, BMW (Bayerische Motoren Werke AG) is a multinational
company that focuses on automobiles. This company is known by people all over the
world for a very long time. Even now, BMW is very successful and has made a lot of
profit. This German company provides its products worldwide, which means they
often face foreign exchange risks.
Transaction’s risk and operating exposure
In 2020, China accounts for the most sales of BMW automobiles, which is
about 33.50%, followed by the United States with about 13.20% of automobile sales.
Meanwhile, Germany, where the company is headquartered, only accounts for
12.30% of the sales, and the rest are the other countries. It implies that Germany only
has a small portion of the company’s sales. That means most of the company’s
revenue would come in the form of foreign currencies that needed to be converted
into Euros as a base currency, including the US dollars, Japanese Yen, Chinese Yuan,
or others. BMW was conscious that its profits were often severely eroded by changes
in exchange rates. This form of risk is also called the economic (operation) exposure,
which is the effect experienced by a company due to unexpected and unavoidable
currency fluctuations on a company’s future cash flows and market value and is long-
term in nature.
Not only affects the company’s revenue it also affects the company’s expenses
where they are buying raw materials for its production from different countries like
Japan. Therefore, the company’s expenses are in foreign currency and for which it is
subjected to exchange rate fluctuations, which poses BMW at risk throughout its
international operations.
BMW’s hedging strategy
To handle these problems, BMW wants to find a way that wouldn’t affect the
company’s performance and its customers. BMW decides to use natural hedge and
formal financial hedge.
Natural hedge, as explained in the previous section, this method is done by
developing ways to spend money in the same currency as where sales were taking
place. BMW uses a natural hedging strategy through which the company tries to
match the currency of its operating revenues with its operating expenses in order to
cancel out any exchange rate effects to some extent. For example, this is done
through:
 Establishing factories in the markets where it sold its products
For example, the company’s plant in South Carolina alone was able to reach
an export value of more than 8.9 billion dollars in 2020. This, therefore,
make the cars that are produced in the United States should be sold in the
United States, thus transactions wouldn’t have to undertake any currency
exchanges.
 Making more purchases of raw materials denominated in the currencies of its
main markets.

However, as natural hedge alone was unable to settle down all of the risks
associated with the foreign exchange fluctuation risks, the company also implement
formal financial hedges to assist the general method. The formal financial hedging
strategy is done through which the company used an internally developed model, that
plans for their foreign exchange hedging. Where an equilibrium rate for all major
currencies that BMW deals with is shown. The difference between the equilibrium
rate and spot rate is then evaluated for evaluating the exposure or risk. Then, the
company issued instructions and risk figures for its global network, while each of the
local treasury centers were to review the foreign exchange risk weekly which is then
evaluated at the central treasury department. For example, when the rate falls below
the equilibrium range i.e., USD1.15/Euro to USD1.17/Euro, the company then uses
forward contracts in order to hedge their revenue

Conclusion
Foreign exchange fluctuation has become a natural phenomenon that is
constantly occurring in the foreign exchange market. This currency’s value
adjustment, however, do not always bring a good impact to either countries or
individuals, as they might have different goals that wanted to be met. In meeting these
goals, different market participants either government, monetary authority, investors,
business owners, etc. are taking steps or actions either through simple selling and
buying of foreign currencies or through wider range of policies, both of these actions
often result in foreign exchange fluctuations that are quite difficult to predict. With
the unpredictability of the foreign exchange market, therefore, parties in the
international market needs different methods in handling and managing different risks
that foreign exchange market might pose. A small or local company usually does
transactions in their currency, which put them away from foreign exchange risks and
fluctuations. However, this doesn’t rule out the possibility for companies that has a
strong competitive position selling a product or service with an exceptional brand may
be able to transact in only one currency, like a US company that insist transactions are
done using their currency, USD. And the other method also has its advantages. In
conclusion, recognize the problem the company face, then, implement the right
method to settle down the risks and foreign exchange fluctuations should be the
number one priority.

References
1) Anurag P. Nitika S. Anu S. GIAN. Hedging Foreign Exchange Risks with
Currency Derivatives. JYOTI E-JOURNAL.
2) Paul A. A Guide to Managing Foreign Exchange Risk. Guide to Managing
Foreign Exchange Risk | Toptal.
3) Elieen Q, Cun H. Building & Sustaining Strategy: Bayerische Motoren Werke
(BMW) – Automotive Industry. TMC Academic Journal.