Tiffany Case

Question #1 solution: Tiffany restructured its Japanese operations by selling directly to the
Japanese market instead of selling to Mitsukoshi and Mitsukoshi selling it to Japan. Tiffany wanted
greater control over its operations in Japan even though demand for Tiffany’s products in Japan declined
from 23% to 15% in 1992. However, Tiffany will still be required to pay fees of 27% of net retail sales in
compensation to Mitsukoshi after this restructuring.

This change in operations exposed Tiffany directly to the exchange rate fluctuations which
Mitsukoshi previously bore. Previously, Mitsukoshi ensured that Tiffany never had to worry about
exchange-rate fluctuations and guaranteed a certain amount of cash flows to Tiffany in their wholesale
transactions. Mitsukoshi bore the risk of any exchange-rate fluctuations that took place between the
time it purchased the inventory from Tiffany and when it finally made the cash settlement.

From exhibit 6 it is shown that yen is strengthening against the dollar and that will increase the
dollar value of Tiffany’s yen denominated cash flows. But there are some market insights that yen will
overvalue and crash suddenly.

Tiffany should be worried about the exchange rate fluctuations because the yen/dollar
exchange rate is very volatile. As the value of Tiffany sales was one percent of $20 billion of Japanese
jewelry market or approximately $200 million. Tiffany faced an additional risk by restructuring its
Japanese operations as Mitsukoshi now no longer controls Tiffany’s sales in Japan.

Question #2 solution: Tiffany should actively manage its yen-dollar exchange risk. Tiffany knows
they will have substantial amount of yen cash inflows from their new arrangement of selling direct in
Japan. If Tiffany does not hedge this currency exchange risk then their earnings will fluctuate. With the
yen-dollar exchange rate being so volatile at this time, it is the best time to hedge in order to help
smooth their earnings and reduce risk. The downside is that options prices are more expensive when
there is more volatility. Since the yen is thought to be overvalued there is speculation that it will
depreciate in the future compared to the dollar. If the yen depreciates and Tiffany converts their yen at
the prevailing spot rate then their dollars received will be decreased.

Question #3 solution: The objectives of managing exchange rate risk should not be to try to
make a profit on exchange rates. Instead the objective should be to reduce risk associated with
economic exposure (medium to long term) and transaction exposure (short-term). Therefore Tiffany
should hedge short term and then roll their position forward. Since the repayment is done on a
quarterly basis Tiffany should cover these exposures for three months to adjust their hedging strategy
on a quarterly basis and hedge that amount minus their inventory repayment to Mitsukoshi.

Economic Exposure; Tiffany is now exposed to foreign exchange rate risk. Tiffany has to bear the
risk of any exchange-rate fluctuations that will take place when it assumes the responsibility for
establishing yen retail price. Tiffany’s foreign operations performance from 1992 to 1993 ($000): 1993
Net Sales= $71,838,
1994 Net Sales= $52,851, 1993 Income/ (loss) from operations= $2,381, 1994 Income/ (loss) from

By: Ramy Hassan

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operations = $3,888. These information indicates that income from Tiffany’s foreign operations
decreased even though net sales increased in 1993. The additional economic exposure that Tiffany is
now exposed to may decrease their income even further which will impact their net sales in the long
run.

Transaction Exposure; the restructuring of Tiffany’s Japanese operations requires Tiffany to

repurchase its inventory. Tiffany is said to repurchase its inventory for $115 million in 1993. However,
Tiffany only managed to repurchase $52.5 million of inventory in July 1993 and Mitsukoshi agreed to
accept a deferred payment on
$25 million of this repurchased inventory, which was to be repaid in yen on a quarterly bases with
interest of 6% per annum over the next 4.5 years. The remaining $62.5 million inventory will be
repurchased throughout the period ending February 28, 1998. Since Tiffany has to repay for inventory
returned by Mitsukoshi on a quarterly basis they can use their cash flows in yen to repay Mitsukoshi and
hedge only the remaining amount

Question #4 solution: To manage exchange rate risk on Tiffany yen cash flows, Tiffany has two
alternatives, the first one by buying yen put option: this option will give Tiffany the right but not the
obligation to sell a yen at predetermined price in future. From exhibit 8(c) strike prices of put exchange
rate are given and premium prices are also given. One month July put options is available at price 1.26
with strike price 94.0, that means Tiffany will sell 106.350 yen for 1 dollar, and another one month put
option at strike price 93.5 is sold at 1.02 premium, there month put option is available at 2.06 with strike
price of 93.5.

The second alternative by entering into forward contract: that means to sell yen to the
counterparty for dollar at a predetermined price in the future, having short position in the contract.
Both parties have obligations to carry out the agreement at expiration. In exhibit 6 there are different
forward and spot rates are given. Let’s suppose we are standing in June 30, there are two forward rates
available in the market, one month forward rate is 106.355 yen per dollar and three month forward is
available at 106.330 yen per dollar. No transaction cost is involved in this contract.

Options gives the right to option buyer at cost of premium, but in forward contract it is
obligatory for both parties at no cost. Suppose if Tiffany enter into 3 month forward contract at 106.330
yen per dollar, and at expiration in September the rates goes up in spot to be available at 112 yen per
dollar, according to forward contracts its obligatory for Tiffany to sell at 106.330, that means Tiffany will
gain 5.67 yen per dollar from this opportunity.

Foreign exchange options you pay the price up front and at expiration you have the option to
exercise. If you buy a call option and at expiration it is in the money you will exercise your option and
buy at the strike price. On the other hand, if the call is out of the money you will buy in the market
place. This means you are not locked in to buying at a set price, but if favorable you have the option to
do so. This is beneficial if you are uncertain you will need to hedge. A forward contract is usually cheaper
and it locks in the exchange rate to be made at a future date. The downside to a forward contract is that
once you enter into it you have to deliver at expiration. This removes downside risk because you are

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guaranteed that exchange rate, but it also takes away upside potential because you have to deliver at
the specified rate. Tiffany should use forward contract for three months to match their yen liability. This
way, as the economy and outlook for sales changes, Tiffany can adjust their hedging strategy on a
quarterly basis and hedge that amount minus their inventory repayment to Mitsukoshi.

Question #5 solution: Tiffany should organize itself to have the treasury department manage
their exchange rate risk. Since there is no information given that Tiffany has a central department to
hedge all of its exchange rate risk we are assuming that each location currently hedges its own risk. If
this is the case the CFO should be responsible for having oversight of managing exchange rate risk, but
an accounting department should be responsible for tracking the profitability of these transactions. The
optimal idea would be to have a central location responsible for managing exchange rate risk, such as
the treasury department. This would reduce costs and reduce the amount of hedging required. Controls
should be in place to ensure that the person responsible for hedging exchange rate risk does not have
oversight over all aspects of the transaction accounting for and monitoring the outcome. Such controls
should include division of duties for accounting for profits of such strategies and the person
implementing the strategies. This would provide checks and balances to ensure that unnecessary or
risky hedging would not take place.

By: Ramy Hassan

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