With the recent restructure of Tiffany Japan, the profits earned by our Japanese division are now exposed to foreign exchange risks that were previously not a concern. In light of this new exposure, it has become imperative that we needed to determine whether or not Tiffany should implement a risk management program using financial derivatives to hedge against this risk. The first step in this evaluation was to determine the amount of profits that could be at risk. To do this, a pro forma income statement (see Table 2. 1) was constructed for the remaining fiscal quarters of 1993.
The income has been estimated by applying the previous years’ seasonality to Tiffany’s one percent market share of Japan’s $20 billion jewelry market. All expenses and other income with the exception of selling, general and administrative (SG&A) and provision for tax expenses were estimated using a trend analysis between fiscal years ended January 31, 1992 and 1993. SG&A expenses were calculated using the 27% agreed upon expense with Mitsukoshi for providing boutique facilities, sales staff, collection of receivable, and security for store inventory.
Whereas, the taxes having seen a large drop between 1993 and 1993, were conservatively estimated using an average percentage between the two years. Using this method of profit estimation, it has been determined that the total Q3 profits that are subject to foreign currency risk are $568,831. This expected positive income puts Tiffany is the long position, which indicates that to balance our risk we would need to consider a short position with respect to the Yen. Over the next three months, the market expects to see the yen appreciating again the dollar and is offering forward rates that are in line with this expectation.
These forward rates would put Tiffany in another long position which would not hedge against our exchange risks. Our next option to hedge against any ForEx risk would be to buy put options which would allow us to achieve a short position without further obligation to proceeds if the yen continues to appreciate as the market foresees. Currently, contracts are for ?6,250,000 per contract. Table 3. 1 gives our current Yen/Dollar foreign currency option prices. Tables 3. 2 through 3. 34 manipulate the put options to better illustrate our options and costs.
In light of the expected yen appreciation, our risk is low enough that I feel it will be unnecessary to ensure 100% of our net income to be matched. With that said I feel that by purchasing 10 contracts at a put price of 93. 5 (100th of a cent) for a total cost of $12,888 we will partially hedge against an unexpected depreciation of the Yen. By purchasing this option, we receive a 3 month option with a strike price of 106. 95 ?/$, which given the current spot price of 106. 35 ?/$ if the yen drops below the 106. 95 we will only lose and estimated $341,299. For a total cost of 2. 26% of our Q3 net income we will maintain 40% of our net income.