Bmw Case Study

Overview:

Bayerische Motoren Werke (BMW) is an automobile manufacturer that carries out its business within three different segments; namely automobiles, financial services and motorcycles. Although the company continues to perform successfully in 2007 they experience some problems that arise from external factors, which some are stemming from the current economic crisis. The company tries to reduce their losses by utilizing currency hedging options.

Problems faced by the BMW:

1. US dollar and Japanese Yen (depreciates): high cost of raw materials & less favorable financing conditions.

2. Affected by external factors (macroeconomic variables): record figures for sale volume and revenues. [Revenue-14.3%=€56,018 million would have been 16.6% without the negative impact].

3. Impact on profitability : US dollar net exposure to the Euro

4. Negative Impact increased cost of market launches for new models.

5. Currency fluctuations

6. Intense global competition in international market.

Questions:

1. How would you evaluate BMW's transaction and operating exposure?

Evaluation of BMW transaction & operating exposure:

Due to the fact that BMW is conducting business in many countries (export/import/production) it is exposed to both transaction and operating risk. With special focus on the US$ and the Euro € exchange rate; Gadaffi investors will now evaluate BMW's transaction and operating exposure.

 Although the company has a production plant in the US, it also has 25% of its sales in the United States. The amount of cars sold in the (United States) market exceeds the amount locally produced and as a result BMW cars had to be imported in order to satisfy the high demand in the US. Exporting BMW cars from Europe to the US can lead to transaction exposure. The transaction exposure would be the order received today for a shipment of cars to the US or payable at a specific time. So here the seller will quote the price to the buyer, the buyer will then place the firm order with seller at priced offered at time t1, the seller will then ship product and bills buyer; therefore that's the accounts receivable and then the buyer settles the accounts receivable with cash in amount of currency quoted at the time t1 (moffett, 2007). The good thing in this transaction is that the amount of cars and the price in the importer currency (US) are known. The risk (transaction) however, is of only importance to the euro worth of the payment in the importer currency (US$) at time 1 and the company that faces it. For example, (FICTIONAL FIGURES USED TO MAKE EXPLANATION CLEARER)

BMW in Europe sells a car on open account for a buyer in the US for $450, 000, payments to be made in 60days

The current exchange rate is €1.18/US

Seller expects to receive

$450,000 * €1.18/US= €531000

Transaction exposure:

* If the US$ weakens, the seller will receive less than €531000

* If the US$ appreciates, the seller will receive more than €531000.

N.b. translation exposure can also occur in this situation, thus resulting in a gain or loss.

 Another transaction exposure that is experienced by BMW stems from being a party to a forward contract. BMW buys forward contracts and options three years out and as a result created transaction exposure. However the risk is incurred to hedge an existing exposure. The derivative financial instruments that BMW used cause the firm to experience losses because there was a change in the market exchange rates.

On the other hand, operating risk involves the change of demand in export to variations in the exchange rate. (Quantities or prices in the domestic currency are uncertain).In 2007, BMW revenue increased by 14.3% to €56,018 million; this revenue could have been increased by 17.6% but it was disturbed by fluctuations in the exchange rate.

When a company identifies the type of exposure it is exposed to due to changes in exchange rates it will have to select a hedging strategy, using forward rates to lock in on an exchange rate and thus eliminating the exposure to the risk.

2. What do you think of BMW's hedging strategy?

To help control the aforementioned exposures, BMW used several hedging strategies, some of the strategies helped minimize risk for the firm, while on the other hand some encouraged losses. But overall we think that the strategies used by the company were efficient and effective.

 Natural hedging- BMW used natural hedging so that its operating revenues and operating expenses should remain in the same currency. In other words cars that are produced in the Euro Countries should be sold in the Euro Countries only. The rationale behind this is that the transactions that have been conducted among the manufacturers and consumers would not have to undertake any currency exchanges. Therefore there will be no currency risk exposure, because all transactions are being made in one currency. In order to satisfy BMW demand in the US, its production plant will have to increase its production volume. With this natural hedging strategy BMW in the US will not have to import any cars from Europe. As a result of this strategy some of the companies risk has been reduced.

 Forward contract & options- BMW used this type of derivative instruments to diversify risk. They have been buying forward contract and options with three year maturities. When they buy forward contract they hedge future losses by giving up future gains; in other words they were not gambling with fluctuations in the market but they were "buying time". By purchasing options, BMW was able to cover its risk exposure among the strike prices. The options work in a way so that when the US currency strengthens the company can buy options and when the currency