Do Exchange Rates Matter?

Contributed by Robert Rowan, an International Finance Controller at SAS and author of new book Foreign Currency Financial Reporting from Euro to Yen to Yuan: A Guide to Fundamental Concepts and Practical Applications

Until 2008 General Motors (GM) reigned as the world’s No. 1 automaker. GM held that position for 76 years. In 2008 Toyota ended GM’s reign, outselling GM by 30,000 vehicles (8.42 million to 8.39 million).

Only a year later, in late 2009, Toyota announced recall after recall. The media seized on the sensational sudden acceleration stories. Toyota dealt with sticking gas pedals, floor mat issues, and braking software issues. The problems led to recall of 16.5 million vehicles.

Recalls add costs that hurt a company’s bottom line. They also tarnish the company’s reputation. However, as the Financial Times noted recently, exchange rates were causing much more concern at Toyota headquarters than were the recalls. The company estimated that every one yen of appreciation against the U.S. dollar reduced their earnings by 30 billion yen, equivalent to 375 million U.S. dollars. This result is due to the fact that a stronger yen makes the exports from Japan more expensive and less competitive, and it creates currency translation losses.

The U.S. government fined Toyota a record $48.8 million related to the recalls. U.S. regulators cleared Toyota of allegations of electronic flaws, and found that the recalls addressed the acceleration problems. Compare the record $48.8 million fine, plus any costs related to the recall, to the $375 million reduction in earnings for each one yen appreciation against the dollar.

Add to that comparison the fact that since the beginning of 2010 an appreciation of 10 yen took place against the U.S. dollar, moving the yen to a 15-year high (see graph below). The result would be a 3.75 billion dollar reduction in earnings based on the Toyota’s estimates of the yen-dollar relationship.

Clearly there are stories that make for sensational reporting and then there are stories not reported that have profound economic consequences for companies and individual investors.

So how does a company protect itself from the vicissitudes of the currency markets? Pam Heye, a treasury management expert based in Raleigh, North Carolina, recently published an article that outlines the simple steps any prudent company takes to manage fluctuations in foreign currency exchange rates.

First a company identifies foreign currency exposures and analyzes foreign currency cash flows. Based on the timing and size of foreign currency cash flows and exposures, a company then can utilize a number of financial instruments to reduce and minimize the impact of fluctuating exchange rates. Such derivative instruments could include forward contracts, options, and swaps.

Of course Toyota needs to manage the opportunity for gain as well. If the 10 yen appreciation had instead been 10 yen depreciation, the company could have realized a 3.75 billion dollar gain when reported in yen. By managing exposure to foreign currency a company chooses between exposure to potential gains or losses, at the mercy of the currency markets, or more certain results that reduce potential for loss but also potential for gain.

View a free sample chapter from Robert's brand new book. And comment here if you would like to share how exchange rates have impacted you/your business.