• Caterpillar 1
• Lufthansa
• FMC
• Union Special
• Laker Airlines
• Finning Tractor & Equipment
• Caterpillar 2
• Chrysler
• Union Carbide
• Monsanto 1
• Digital Equipment Corporation
• SmithKline
• Dow Chemicals
• Monsanto 2
• Merck Pharmaceuticals
• Kodak
• Magma Copper
• Allied Lyons

Background

Currency or transactions risk, the economic consequences of the fluctuation of exchange rates, strongly affects many businesses in a variety of ways. In the early 1980's the tight monetary policy of the Fed resulted in high real interest rates in the U.S. compared to other countries. This in turn resulted in a high value of the dollar compared to other currencies.

• Caterpillar

  As a consequence of the high value of the dollar in the early 1980's, Caterpillar, historically a world leader in construction equipment, found itself at a distinct disadvantage in competition with Komatsu, a Japanese manufacturer of hydraulic excavators. Later in the 1980's U.S. monetary policy eased after the decline in inflation and U.S. interest rates fell. The value of the dollar also fell as foreign investors were no longer so interested in trading their currencies for dollars to invest in U.S. financial markets.

  In 1986 Caterpillar had a $100 million profit on foreign exchange that turned its $24 million operating loss into a $76 million profit for the year. As a result of its experiences Caterpillar established a special company group to manage currency risk.

  Other companies did not fare so well.

• Lufthansa

  Lufthansa, the German airline, contracted with Boeing to purchase aircraft in the mid-1980's when the value of the dollar was increasing. The price was set in dollars and Lufthansa was afraid that the dollar would strengthen, increasing the Deutsche mark cost of the planes. In 1986 Lufthansa entered into forward contracts for the dollars required to pay for the planes. Although Lufthansa feared a strenghtening of the dollar what actually happened is that the dollar weakened. The forward contracts cost Lufthansa $140 to $160 million more for the planes than if it had simply waited and purchased the dollars on the spot market.

• FMC

  FMC in 1988 had 88 facilities in 15 different countries and derived one third of its $3.3 billion sales revenue in international markets. Its Irish subsidiary produced an ingredient for aspirin tablets that it sold to European aspirin manufacturers. A strengthening dollar would make it difficult to maintain its market share. FMC used forward contracts and currency options to hedge against a strengthening dollar and used the profits to enable the Irish subsidiary to cut prices and maintain its competitive position even in face of an strengthening dollar. FMC's hedging extended out three years and this made the forward contracts a risky strategy, particularly since it anticipated sales revenue that might not materialize.

  FMC's strategy was an example of a financial hedge. There are also operating adjustments and natural hedges. For example, if the dollar weakens then Japanese car companies may supply more of their American market sales from U.S. sources, either manufacturing cars in the U.S. or buying components from dollar sources (or from sources such as Korea or Taiwan whose currencies are tied to the dollar). If the dollar strengthens compared to the yen then their U.S. sales will be more heavily supplied from Japanese sources. This strategy is basically a matter of matching the currency of costs with the currency of revenues.

  There are various considerations in quantifying the foreign exchange risks of a company. One approach is to tabulate the costs and revenues versus currencies. This assumes that prices in the countries of the origins of transactions will remain fixed in the face of foreign exchange shifts. In other words, this ignores the adjustments that might occur as a result of the new currency values.

  The adjustments described above are legitimate actions on the part of multinational businesses. There are other adjustments of questionable validity. For example, a study by Richard Marston of the Wharton School of Business of the University of Pennsylvania concluded that "Japanese firms vary their export prices relative to their domestic prices in response to changes in real exchange rates." As Millman puts it, "when the yen becomes strong (expensive), Japanese manufacturers raise their domestic prices while keeping their export prices constant." This can happen only if the Japanese domestic market is shielded from effective foreign competition.

• Union Special

  Union Special - A small, Chicago-based manufacturer of sewing machines. Its sales were in the $100 million per year range and until the late 1980's it had no explicit foreign exchange rate risk strategy. But, as Millman points out, by doing nothing it actually did have a strategy; i.e., it bet the entire company on the changes in the floating exchange rate.

  Fifty percent of Union Special's were outside of the U.S. but it did 80 percent of its manufacturing domestically. In the 1970's it had about 25 percent of its manufacturing capacity in Germany but it reacted to its declining profits in the early 1980's by consolidating its production in the U.S. Instead of matching currencies of costs and revenue it chose to mismatch them. It then tried to maintain market share by cutting prices in the face of the strengthening dollar. The result was major losses and in 1988 the company was taken over by Japanese buyers.

• Laker Airlines

  Sir Freddy Laker - Laker pioneered low cost trans-Atlantic travel. He primarily sold American vacations to British travelers. He started out at a time when the pound was strong and the dollar weak. Business was good and he contracted to buy American aircraft at a price set in dollars. When the dollar strengthened not only was his pound revenue worth less in terms of dollars so more pounds had to be devoted to paying for the new planes but the weaker pound resulted in less travel. Laker had fewer pounds but a bigger bill for the planes. The result was bankruptcy.

• Finning Tractor & Equipment

  Finning Tractor & Equipment Company of British Columbia, Canada- Finning was a dealership for Caterpillar. Even before the high value dollar period of the early 1980's Caterpillar equipment cost about 15 percent more than Komatsu equipment, but the service provided by Finning overcame the price disadvantage. The strong dollar of the early 1980's turned Komatsu's 15 percent price advantage into a 40 percent price advantage. Finning knew that once Komatsu built up its business it would establish a service network that would offset the service advantage of Caterpillar. Finning tried very hard to keep Komatsu from establishing itself in British Columbia. It lost. But Komatsu hoped to make up for the low price on the equipment by charging high prices for replacement parts. The cost of replacement parts in three years equals the initial price. The Komatsu equipment buyers were shocked at the price of Komatsu replacement parts. But the Komatsu equipment was so close to Caterpillar models that Finning was able to sell Caterpillar parts to Komatsu customers at a lower cost. The experience of being "held up" by Komatsu on replacement parts resulted in those customers returning to Caterpillar the next time they bought equipment.

• Caterpillar

  Caterpillar -- After sustaining a $953 million loss over the 1982-84 Caterpillar was acutely conscious of its exposure to foreign exchange fluctuations, particularly the yen, and foreign currency risk management a major focus of its corporate strategy. As a consequence in 1985 about 45 percent of its $198 million profit ($89 million) was from foreign exchange gains. And as mentioned before, in 1985 the $100 million foreign exchange gains more than offset its $24 million operating profit loss.

• Chrysler

  Chrysler - At one time Chrysler had extensive overseas operations, but its restructuring in the late 1970's involved selling off its European, Latin American and Australian subsidiaries. Chrysler then became a company with negligible foreign manufacturing and marketing. Its foreign exchange exposure was then almost entirely as a result of the value of the yen on its market share in the U.S. automobile market. Japanese car makers had a cost advantage of about $2000 per car in the early 1980's. Chrysler management decided that Chrysler simply could not compete in the low end of the market and should rely upon offshore sources for that segment of the market. Chrysler entered into a contract with Mitsubishi Motors Corporation for V6 engines. This contract became the major element of Chrysler's foreign currency exposure.

  The contract, negotiated in 1983 and 1984, stipulated that for exchange rates from 240 to 220 yen to the dollar Mitsubishi would absorb the entire cost of an exchange rate change. Within the range 220 to 190 yen to the dollar, Chrysler and Mitsubishi split the cost of exchange rate shifts evenly. In the range 190 to 130 Chrysler bore 75 percent of the costs of exchange rate shifts and below 130 Chrysler had to absorb the entire cost. When the value of the yen dropped Chrysler began hedging in a big way. Chrysler tried to predict yen exchange rates out to ten years. In the auto industry it takes about five years to go from a decision to produce a product to putting it on the market. Because of the increasing prospective costs associated with the Mitsubishi contract, Chrysler management decided to produce the V6 engine within the company.

  In about 1990 Chrysler was buying about $14 billion annually in North America. This did not include about $3 billion of spare parts. Chrysler had about $1.3 billion in exchange rate exposure from purchases out of North America (about two thirds from the Mitsubishi contract). Once a month, a committee prepares a report on Chrysler's exchange rate exposure. After a hedging committee decides on strategy, a trading group implements the hedging committee's plan. Historically Chrysler used forward contracts to hedge, but since 1988 currency options have become an important element for hedging. The trading is relatively conservative. Only the net exposure is hedged. The traders are kept in their jobs for eighteen months whereas elsewhere in the company people are moved on to new positions after twelve months.

  Chrysler generally has been satisfied with their foreign exchange operations and is considering systematically hedging other risks such as interest rate fluctuations.

• Union Carbide

  Union Carbide, one of the world's major chemical companies, views foreign currency risks as a money making opportunity. That is to say, it does not just hedge its exposure but aggressive trades in an attempt to make a profit. The operating units sell their foreign currency exposures to a company currency risk management unit. A task force of thirty people manage Union Carbide's currency operations. The task force is broken down into working groups of four or five who deal with special issues such as managing currency risk in hyperinflationary countries. The task force focuses on managing short term (one year) currency risks but it is recognized that it is long term (five year) risk management that is important for the financial health of the company.

  The actual currency transactions are carried out by a small number of traders, known as currency risk managers. The staffing of these positions raises some problems. Here is what Union Carbide's treasurer and CFO had to say on these matters:

  [...]I have decided that I don't want to have career foreign currency risk managers at Union Carbide. On the one hand, I don't want to compete with all of the commercial banks and investment banks around the world for career foreign exchange people.[...]That's one element. Another element is that I put only my brightest high-potential people in that group, and their careers at Union Carbide are not determined on the basis of how much money they make for Union Carbide in the currency risk area.

• Monsanto

  Monsanto is another American chemical company that is a world supplier of chemicals. In 1988 40 percent of Monsanto's income came from sales in Europe, Asia, Latin America and Canada. In the 1970's Monsanto established a committee of senior financial and operating managers to evaluate the effects of currency exchange rate shifts on company profits. By the 1980's a unit within the corporate treasury was given responsibility for managing currency risk. This treasury unit however works closely with operating managers in handling Monsanto's currency risk.

  Operating divisions within Monsanto hedge their annual operating plans to lock in reported income results. For example, in 1988 Monsanto Agricultural Company intended to cut the sterling price of its products in the United Kingdom, but it was worried that a weakening of the pound would turn a possible mild decrease in dollar profits from the UK into a disasterous decrease. Monsanto chose to hedge against a decline in the pound by buying currency put options. If the market price of sterling declined the profit on the options would offset the decreased dollar-value of the sterling revenues. The put options cost Monsanto $700 thousand but it gave protection with a limited risk and allowed it to benefit from any possible increase in the value of the pound.

  In the middle of the 1980's there occured an episode that illustrates the difficulties of managing properly in the face of rapidly shifting exchange rates. Monsanto Agricultural found in both the dollar price of its products and the physical volume of its sales decreasing. It reacted by carrying out a heavy advertising campaign which did not work. After pursuing other erroneous theories it finally concluded that the problem was that in the local markets its product prices were increasing relative to other prices. Monsanto had tried to maintain a constant dollar price by translating changes in the exchange rates directly into local currencies. But in areas of high inflation the exchange rates are harder hit by inflation than the domestic market so in local terms Monsanto's prices were increasing about twice the rate of inflation. Understandably Monsanto was losing market share to competing products. Monsanto found it essential to look at local prices in pricing its products.

• Digital Equipment Corporation

  Digital Equipment Corporation (DEC) is an American manufacturer of computers. The computer industry was once described as being Snow White and the Seven Dwarves, with IBM being Snow White. DEC is one of the dwarves. It was quite successful in the era of the minicomputer and in the 1980's its business grew and became increasingly international. The proportion of its sales which were outside of the U.S. rose from 39 percent in 1980 to 56 percent in 1988. Of its 130,000 employees, 50 to 60 thousand were based outside of the U.S.

  DEC wants to appear to be a local company in its foreign markets. For this reason it does not want to adjust its foreign currency price with each shift in the exchange rate. This eliminates one type of natural hedge adjustment for DEC.

  In the late 1970's DEC hedged part of its foreign currency revenues. During the era of the weakening of the dollar the unhedged portion of its revenues produced gains for the company. But in the era of the strengthening of the dollar in the early 1980's that unhedged portion produced losses. In 1982 top management decided that selective hedging was sheer speculation and the decision was made to hedge all foreign currency revenues. In 1984 DEC decided to change its accounting system so that hedge gains and losses would reported in the results of operating managers. The operating managers objected to being evaluated on the basis of results that reflected hedging gain or losses which they had no control over. At one point in 1988 a senior manager recommended that all hedging be done away with. But that would result in swings of 20 to 25 percent in quarterly earnings. That was considered unacceptable. DEC had abandoned selective hedging in 1982 and if zero hedging was unacceptable the only alternative was 100 percent hedging. And that is what they did.

  As soon as a future foreign currency flow becomes certain it is converted into dollars through a forward market transaction. This eliminates the variability of the reported accounting results.

  This policy of complete hedging using the forward markets is justified on the basis that the currency markets are informationally efficient so that trying to outguess the market is fruitless and merely gambling. DEC generally does not use options either. It justifies this with the argument that options are expensive hedges where as the forward contract costs nothing.

  DEC considers its foreign currency risk to have two parts, a short term component and a long term component. The short term component it handles through complete hedging in the forward market. The long term component it tries to handle through shifts in sourcing, manufacturing operations and other such natural hedges.

• SmithKline

  SmithKline merged with Allergan and with Beckman in the early 1980's to become a major multinational pharmaceutical firm, SmithKline Beckman. It continues to pursue growth through mergers.

  The economics of the pharmaceutical industry is dominated by research costs. Production costs are a much less significant factor than in other industries. Therefore shifts in exchange rates play a lesser role in operations for this industry because the gains from adjustments in sourcing and manufacturing are less important. Demand is also thought to be insensitive to price and in many countries the prices of pharmaceuticals are regulated. Despite this supposed price insensitivity SmithKline Beckman felt it benefited from the weakening dollar in the late 1980's.

• Gregory J. Millman, The Floating Battlefield: Corporate Strategies in the Currency Wars (New York, AMACOM, 1990).

• Gregory J. Millman, The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central Banks (New York, The Free Press, 1995).