Car Manufacturers in the World - Thesis Example

Use of Financial Derivatives by Porsche Name Course Date A. Foreign exchange risk analysis: Impact on profitability Key points As of 2005, Porsche was a family owned business that manufactures about 100,000 cars a year. The company has been making gains over the years and it was able to acquire 50.76% of share in Volkswagen in 2009. The company was also considered as one of the most valuable brands in the world. In the 2002 financial year, the company made a sale of € 5,582 million and the production was 73,284 units (Porsche, 2016). The company continued increasing its production as well as sales and in the 2005 financial year it produced 90,954 units and it made a sales of € 6,574 million. This is an indication that the company underwent rapid growth during the period. In 2005, the domestic sales accounted for € 1,267 million and the export accounted for € 5,307 (Porsche, 2016). Hedging of the foreign exchange exposure is a measure that is utilized by the company to deal with the foreign exchange rate risks. This is usually achieved by buying two-year European at-the-money put options on the US $. Porsche group highlights, Source, 2005 annual report Key points BMW is one of the ten largest car manufacturers in the world. To improve on the profitability of the various initiatives were put in place in 2001 which involved expanding the product range and strengthening the worldwide market position. In 2002 financial year, the company was able to generate a revenue of € 42,411 million and the amount increased to € 46,456 million in 2005 (BMW Group, 2016). About 1.5 million units were produced in 2005 which was up from 1 million in 2002. BMW produces a variety of products which includes cars and motorcycles. The company has been able to emerge successful despite the difficult operating environment. Since the company has operations worldwide, it is faced with foreign exchange rate risks that have negative impacts on profitability. In order to deal with the foreign exchange rate risks, the natural hedge strategy is being utilized by the company. The formal financial hedges are also utilized by the company to cover up for the weaknesses associated with the natural hedging (Ringe, 2012). BMW highlights, Source, 2005 BWM annual report Volkswagen is an automaker that is owned by Volkswagen Group which is the largest automaker worldwide. The company has been in operation since 1937 and it currents serves the worldwide market. In 2004, the company was able to produce 5,093,181 units and it earned revenue of € 88,963 million. In 2005, the company was able to produce 5,219,478 units and the sales during the year was € 95,268 million which was a remarkable improvement from 2004 (Volkswagen AG, 2016). The worldwide operation of the company exposes it to different types of risks. The financial risk rate is one of the main risks that the company is exposed to. This can be attributed to its equity investments in joint ventures that hold several businesses across Europe as well as other parts of the world. The fair value as well as earnings of the company in non-US holding is greatly affected by the changes in currency rates. The sole exposure of the company is to the Euro (Volkswagen AG, 2016). The company utilizes the hedging instruments in order to caution itself from the currency exchange rate risks. Volkswagen group highlights, Source, 2005 Annual report Foreign exchange exposures Key points The introduction of the Euro as the common currency for the European Union countries was mainly aimed at reducing the risk of managing the corporate cost of managing the exchange risks for European firms. The exchange rate movements usually affect the discount rate used and hence impacting negatively on the future cash flows as well as the value of a firm. A decreasing cash flow from the foreign sales is one of the major risks associated with the exposure if the domestic currency depreciates (Ringe, 2012). However, an appreciation of the domestic currency may lead to benefits for the company. The existence of assets and liabilities abroad may also contribute to the exposure. Porsche, BMW and Volkswagen have assets as well as liabilities abroad due to the global operations. The Euro was introduced in 1999 and it was immediately used in Germany where the three companies were based. Foreign exchange exposure graph The exchange rate of the US dollar to the Euro in January 2001 was 0.94. This means that the 1.00 Euro was bought for USD 0.94. Between 2001 and 2005, the Euro continued to strengthen against the US dollar. In December 2004, 1 Euro was being bought by USD 1.34. In December 2005, 1 Euro was bought at USD 1.19.This is an indication that the Euro remained string throughout the period despite the fluctuations (Auer & Schumacher, 2013). The three companies did not suffer much from the exchange rate risk during the period. The exchange rate however indicates that in areas where the dollars were used, the companies suffered some losses during the conversion to Euros. All the three companies however utilized hedging to manage the risks associated with the exchange rate risks. Euro/USD exchange rate 2001-2005 Companies need to adapt quickly when the currency undergoes changes. Supply and demand is one of the main aspects that influence the exchange rate between the Dollar and the Euro. Porsche foreign exchange exposure A trade deficit between the USA and the countries using the Euro was created during the fall of the dollar between 2002-2005 (Stowel, 2012). A weak dollar has negative impacts on the manufacturing companies and this includes the automotive industry. This can be attributed to the impacts of the strong Euro on the exports. BMW, Porsche and Volkswagen were all affected by the weak dollar. Volkswagen foreign exchange exposure Although the companies did not make losses during the time, they had to spend more in absorbing the losses as opposed to passing the price increase to the customers. The weak dollar meant that the export and import activities of the companies were affected (Baur, 2015). Germany and the European Union is a major trading partner of the USA and any effects on the dollar has impacts on the businesses operating in the countries. It is for this reason that hedging is the most preferred method of cautioning the companies from the exchange rate risks by all the three companies based in Germany. BMW foreign exchange exposure B. Foreign exchange hedge policy and corporate international strategy Key points Foreign exchange hedge is a method that is used by companies to eliminate the foreign exchange risk that results from transaction in foreign currencies. Various tools are usually used leading to the transfer of the risks to a business that carries the risk such as the bank. However, setting up a hedge has its own disadvantages as it will have to forego any profit in case the exchange rate ends up being favourable to it (Stowel, 2012). The multinational companies are exposed to the foreign exchange risk rate as they operate in different countries where different currencies are used. When dealing with receivables, the companies must exchange foreign currencies for home currencies. A hedge is considered a financial derivative that derives its value from an underlying asset. The two most commonly used hedges include the forward contracts and options. A forward contract locks in an exchange rate for today in relation to the transactions that will occur in future. Porsche currency hedging Option involves a set of exchange rate at which the company may choose to exchange currencies (Auer & Schumacher, 2013). In most cases, the company does not exercise this option if the currency is favourable. When using the forward contract, the other party benefit from the risks. However, it is the organization that benefits when the option is used. The volatility of the market is one of the main reasons as to why the companies hedge. Volkswagen, Porsche and BMW have all been involved in hedging for the purposes of managing the foreign exchange risks. Volkswagen is exposed to the foreign exchange risks due to its joint ventures as well as global operations. The home currency of the company is the Euro which is the sole currency that it is exposed to. The fair values and earnings of the company are affected by the changes in the currency exposure. Volkswagen mitigates the risk by utilizing the currency instrument in order to hedge the capital portion of its foreign currency risk (Stowel, 2012). The costless collar is the hedging instrument that has been applied by the company over the years. This involves buying a protective put while writing an out of the money covered call with a strike price. When using this instrument, the premium received is usually equal to the premium of the protective put purchased. When using the strategy, the puts were structured with strike prices that are approximately 10% lower than the cost basis of the company in such investments. This played an important role in limiting the Euro related foreign exchange in terms of fluctuations to about 10% of the original capital invested in the deal. Volkswagen utilizes six outstanding hedging instruments with an aggregate notional amount of € 11.1 million (Volkswagen AG, 2016). The major international banks as well as the financial institutions are the counterparties in the management of the risks by the company. This is mainly for the purposes of avoiding further credit loss that is associated with non-performance. The chances of non-performance by the major international banks and institutions are much lower. Global sales to countries such as China, Russia and India accounts for 14% in BMW. The sales at the domestic market in Germany accounts for less than 20% (BMW Group, 2016). This therefore exposes the company to the foreign exchange rate risk. The rising profits of the company was however being affected by the changes in the exchange rates The recent reports of the company indicates that the negative effects of the exchange rate totaled about € 2.4 billion between 2005 and 2009.The company has always avoided passing the exchange rate costs to the customers as its sales may be affected. BMW embraced the natural hedge in order to deal with the risk. This strategy involves developing ways to spend money in the same currency as where the sales take place. This strategy ensures that the local currencies are used in the determining the revenues in the countries of operation. The other strategy that was also put in place by the company involved the formal financial hedges. Formal financial hedges were also used by the company and regional treasury centers were set up in the US, UK and Singapore (Ringe, 2012). Natural hedge was implemented in two ways by the company. The first method involved setting up factories in the markets where it sold its products. The second method involved making more purchases that is denominated in the currencies of its main market. The overseas regional treasury centers usually review the exchange rate exposure in the regions every week. The company is also actively involved in sourcing parts overseas in order to diversify the supply chain risks (BMW Group, 2016). Currency play strategy was utilized by Porsche in order to effectively manage financial risk exposure. When the dollar was low as compared to the Euro, the company was still able to make profits. At the period between 2002-2005, the other companies including Volkswagen and BMW experienced a plunge in profits due to the strengthening of the Euro against the dollar. Porsche was able to make bout € 1.1 billion during the time. About 75% of the profits that the company earned were due to smart currency plays (Baur, 2015). The option hedge strategy was used by the company in order to deal with the exchange rate risks. Porsche entered into a contract to buy Euros while the dollar was low. Porsche was able to make huge profits when the euro appreciated. The strategy enabled the company to cap its losses at the prices of the premium which ranged from 1.5-2%. The strategy meant that the appreciation of the dollar would limit the losses made by the company by less than 20 million (Mollers, 2015). This strategy was thus considered one of the most effective by the company. The corporate values play an important role in influencing the strategy that is used by to manage the exchange rate risks. Each company adapts to a different strategy that best suites its practices. The companies that embark on the global strategy are affected by the exchange rate risks. The hedging strategy is an important aspect that has to be undertaken in order to mitigate the impacts of the risks associated with currency exchange risks. Porsche revenue and vehicle production, Source, 2005 Annual report C. Financial vs. Industrial logics: Was Porsche behaving like a hedge fund? Key points Porsche used derivatives in dealing with the Volkswagen stock for the purposes of ensuring that huge profits were made. This move was considered smart by most of the analysts. Porsche started by building its stake in order to ensure that it controlled Volkswagen (Mollers, 2015). The actions of Porsche led to the prices going up and this had an impact on the hedge funds. The hedge funds realized that the share prices would fall as soon as Porsche got control of Volkswagen and this led selling of the shares short. The actions of Porsche led to only a few shares that were not available to anyone to remain. This action in turn caused the shares to gain value from 200 Euros to a high of over 1000 Euros. This led to Volkswagen being declared the world’s most valuable company. Porsche created a gap in the market and hence acting as a hedge (Milne, 2007). This means that it was not necessary for it to purchase more share of the Volkswagen although it profited from it. It had to accept the cash difference between the market price and the price that it had agreed to pay. The situation led to the generation of billions of Euros in profit without much effort. The actions of Porsche are an indication that it acted as a hedge and it thus benefited from the gap that it created. This is the same as the financial institutions that acts as a hedge and benefits when the exchange rate is favourable. At Volkswagen, corporate governance is based on the recommendations of German Corporate Governance Code. The recommendations are usually comprised of the best corporate governance standards both nationally and internationally. The corporate governance strategies of the company are thus aimed at enhancing transparency as well as trust among the stakeholders. The actions of the company are usually in the best interest of the national as well as the international investors. Systematic risk management strategies are also in place at the company as part of corporate governance. The high levels of transparency have seen the company publishing detailed information of its financial results (Volkswagen AG, 2016). The board of management as well as the supervisory board plays a vital role in the implementation of the corporate governance strategies. The company has also made a declaration with the corporate governance code. At Porsche, there is a high level of compliance with the non-mandatory regulation of the corporate governance code. However, the company does not comply with a number or regulations due to company specific factors. The company has indicated that it will not comply with the requirement of holding annul detailed discussions with the auditors about the annual accounts of the company. Unlike Volkswagen, the company is highly secretive when it comes to the financial issues. It is for this reason that the company almost took over Volkswagen as its plans and strategies were not known. Detailed information about the stock issues as well as executive pay is not disclosed in details by the company (Porsche, 2016). Volkswagen was able to counter the takeover threat that was posed by Porsche. The announcement was made by Piech who is the chairman of Volkswagen. He went ahead and declared victory over Wiedeking who was the chief executive of Porsche. There was a power struggle between the two since Porsche tried to take over Volkswagen. This happened after Porsche was about to triple its net debt to € 9 billion in the process of trying to increase its stake on Volkswagen. Porsche’s business was also tumbling as a result of the debt leaving it with less cash to pay the interest on the debt (The economist, 2016). The market condition at the time was not favourable to Porsche and this meant that it could not borrow much. The company was therefore forced top pledge its Volkswagen shares to the bank with a promise of repaying € 3.3 billion within six months. The repeal of Volkswagen law that Porsche was counting on did not materialize making it impossible to access the ash reserves of the Volkswagen which stood at € 10.7 billion (The economist, 2016). The inability of Porsche to settle its debt and the refusal by Volkswagen to absorb the dept meant that Piech had uncontested control of Volkswagen. In the end, Wiedeking was forced to step down in order to pave way for a merger. Was widely blamed for the challenge the company was faced with after the failure of the takeover bid. However, he was also credited for improving on the performance of the company. Most of the analysts have equated the behavior of Porsche as a hedge fund. This can be attributed to its activities as well as the methods of operation. The company was able to earn three times as much money from trading derivatives as compared to selling cars (Milne, 2007). This is despite selling of cars being its core business. The company has also indicated that the source of its profits is from hedging as well as selling cars. Options was used by the company to hedge against the likelihood of Volkswagen shares rising after its interest was made public. Option trading accounted for about € 3 billion in the second half of 2005 (Mollers, 2015). The company also put in place measures such as raisin its dividends. The company is much smaller as compared to Volkswagen but is almost took over the company due to trading in derivates as opposed to selling of cars. The strategy that the company utilized had never been seen before in the German automotive industry. However, the company was also exposed to some risks which almost contributed to its downfall. It is for this reason that Volkswagen was able to turn the tables against the takeover. Bibliography Milne, R., 2007. Porsche on fast track to profit from share options. Financial Times. Retrieved on 29th October 2016 from, . The economist, 2016. Piech in the driving seat. Retrieved on 29th October 2016 from, . BMW Group, 2016. Annual Report 2005. Retrieved on 29th October 2016 from, . Volkswagen AG, 2016. Annual report 2005. Retrieved on 29th October 2016 from, . Porsche, 2016. Annual report 2004/2005. Retrieved on 29th October 2016 from, . Mollers, T.M., 2015. The takeover battle Volkswagen/Porsche: the piech-porsche clan family clan acquires a majority holding in Volkswagen. Capital Markets Law Journal, 10(3), pp. 410-430. Baur, D.G., 2015. Case Study: Porsche versus Volkswagen. Available at SSRN2649141. Stowel, D., 2012. Investment banks, hedge funds and private equity. Academic press. Ringe, W. G., 2012. Hedge funds and risk decoupling: The empty voting problem in the European Union. Seattle UL Rev, 36, p.1027. Auer, B. R., & Schumacher, F., 2013. Robust evidence on the similarity of Sharpe ratio and drawdown-based hedge fund performance rankings. Journal of international financial markets, institutions and money, 24, pp.153-165. Read More