Review the “Case Application” at the end of Chapter 9: Exchange Risk Management at Merck.
Using the 5-step process outlined, develop your own 5-step program for managing exchange risk for your proposed acquisition. Your proposal must be three to five pages (excluding title and reference pages) in length.
To further examine how companies actually manage exchange risk exposure, we choose Merck & Co. Incorporated, a major U.S. pharmaceutical company, and study its approach to overall exchange exposure management. While Merck’s actual hedging decision reflects its own particular business situation, the basic framework for dealing with currency exposure can be informative for other firms.
Merck & Co. primarily develops, produces, and markets health care pharmaceuticals. As a multinational company that operates in more than 100 countries, Merck had worldwide sales of $6.6 billion in 1989, and it controlled about a 4.7 percent market share worldwide. Merck’s major foreign competitors are European firms and emerging Japanese firms. Merck is among the most internationally oriented U.S. pharmaceutical companies, with overseas assets accounting for about 40 percent of the firm’s total and with roughly 50 percent of its sales overseas.
As is typical in the pharmaceutical industry, Merck established overseas subsidiaries. These subsidiaries number about 70 and are responsible for finishing imported products and marketing in the local markets of incorporation. Sales are denominated in local currencies, and thus the company is directly affected by exchange rate fluctuations. Costs are incurred partly in the U.S. dollar for basic manufacturing and research and partly in terms of local currency for finishing, marketing, distribution, and so on. Merck found that costs and revenues were not matched in individual currencies mainly because of the concentration of research, manufacturing, and headquarters operations in the United States.
To reduce the currency mismatch, Merck first considered the possibility of redeploying resources in order to shift dollar costs to other currencies. The company, however, decided that relocating employees and manufacturing and research sites was not a practical and cost-effective way of dealing with exchange exposure. Having decided that operational hedging was not appropriate, Merck considered the alternative of financial hedging. Merck developed a five-step procedure for financial hedging:
Exchange forecasting.Assessing strategic plan impact.Hedging rationale.Financial instruments.Hedging program.
The first step involves reviewing the likelihood of adverse exchange movements. The treasury staff estimates possible ranges for dollar strength or weakness over the five-year planning horizon. In doing so, the major factors expected to influence exchange rates, such as the U.S. trade deficit, capital flows, the U.S. budget deficit, and government policies regarding exchange rates, are considered. Outside forecasters are also polled on the outlook for the dollar over the planning horizon.
Once the future exchange rate ranges are estimated, cash flows and earnings are projected and compared under the alternative exchange rate scenarios, such as strong dollar and weak dollar. These projections are made on a five-year cumulative basis rather than on a year-to-year basis because cumulative results provide more useful information concerning the magnitude of exchange exposure associated with the company’s long-range plan.
In deciding whether to hedge exchange exposure, Merck focused on the objective of maximizing long-term cash flows and on the potential effect of exchange rate movements on the firm’s ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholder wealth. Merck decided to hedge for two main reasons. First, the company has a large portion of earnings generated overseas while a disproportionate share of costs is incurred in dollars. Second, volatile cash flows can adversely affect the firm’s ability to implement the strategic plan, especially investments in R&D that form the basis for future growth. To succeed in a highly competitive industry, the company needs to make a long-term commitment to a high level of research funding. But the cash flow uncertainty caused by volatile exchange rates makes it difficult to justify a high level of research spending. Management decided to hedge in order to reduce the potential effect of volatile exchange rates on future cash flows.
The objective was to select the most cost-effective hedging tool that accommodated the company’s risk preference. Among various hedging tools, such as forward currency contracts, foreign currency borrowing, and currency options, Merck chose currency options because it was not willing to forgo the potential gains if the dollar depreciated against foreign currencies as it has been doing against major currencies since the mid-eighties. Merck regarded option costs as premiums for the insurance policy designed to preserve its ability to implement the strategic plan.
Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options, and the percentage of income to be covered. After simulating the outcomes of alternative implementation strategies under various exchange rate scenarios, Merck decided to (1) hedge for a multiyear period using long-dated options contracts, rather than hedge year-by-year, to protect the firm’s strategic cash flows, (2) not use far out-of-money options to save costs, and (3) hedge only on a partial basis, with the remainder self-insured.
To help formulate the most cost-effective hedging program, Merck developed a computer-based model that simulates the effectiveness of various hedging strategies. Exhibit 9.12 provides an example of simulation results, comparing distributions of hedged and unhedged cash flows. Obviously, the hedged cash flow distribution has a higher mean and a lower standard deviation than the unhedged cash flow distribution. As we discuss in Chapter 8, hedging may not only reduce risk but also increase cash flows if a reduced risk lowers the firm’s cost of capital and tax liabilities. In this scenario, hedging is preferred to no hedging