Exchange rate fluctuations between the Japanese yen, the euro, and the US dollar have posed serious problems for Strato Designs (the name of the company is disguised).

The California company produces graphics components for nine of the top ten PC makers, other specialty logic chips for PCs, and modems. Approximately 35% of its sales are to Japanese companies, and approximately 10% to European companies.

Japanese customers require that prices be quoted in yen, and many European customers are now requiring that prices be quoted in euros. Payments in foreign currencies could, of course, be converted to dollars at the spot (current) exchange rate when received. However, when the yen or euro has increased in value between the time of price quotation and the receipt of payment, it means a windfall profit for Strato Designs. A decrease in the value of the yen or euro means an exchange loss that might exceed the margin on the sale, resulting in a loss on the sale.

The fluctuations in exchange rates over the past ten years have been substantial and unpredictable. From its launch in January 1999, the euro lost over 30% of its value relative to the dollar by October 2000. It rallied, fell again, and then greatly increased. At one point in 2007, the euro stood at 1.35 per dollar, an increase of over 55%

from its low. The British pound has increased in value against the euro as well as against the dollar. During the 1999–2007 period, the yen moved up and down in a range of about 25% relative to the dollar. Daily fluctuations were sometimes substantial. Short-term changes in the value of the yen were dampened somewhat by massive Japanese government interventions in the foreign exchange market.

Overall margins in the industry are not high enough to allow Strato Designs to make quotations to cover possible losses due to a weakening of a foreign currency. Even windfall profits from a strengthening foreign currency could be a problem for the company. Foreign customers who contracted for products when their currencies were weak, and subsequently paid when their currencies were strong, would realize that they were paying high prices in dollars. They might ask for rebates if Strato Designs’ competitors were offering products at lower prices based on revised exchange rates.

Company officials discussed the problem with their bank, and with other companies facing similar problems, using the yen as an example. At least six strategies are available:

1. The company could enter into a forward exchange contract to sell the yen for dollars at a specified date in the future for a specified price. The date for sale of the yen (purchase of dollars) would be set for the time when the yen would be received from the Japanese importer of the goods. Such a contract, available at a relatively low price and usually with a rate very near to the spot rate, would lock in the profit. But it would also prevent Strato Designs from benefiting from a windfall profit. Further, it would not solve the potential problem of having a dissatisfied customer if the yen became stronger during the period between the sales contract and the time of payment.

2. The company could purchase an option to sell the yen (buy dollars) at a specified rate at the date when the yen are due to be received. With an option, Strato Designs would not have to sell the yen to the option provider. It could do so if the yen had become weaker, or it could simply not exercise the option and instead sell the yen at the spot rate (current rate) if the yen had become stronger. The disadvantage of this method is that options are relatively expensive to purchase.

3. Strato Designs might be able to arrange a swap of currencies at a predetermined rate with a US-based exporter who will need to pay yen at the time that Strato Designs will receive yen.

4. Depending upon Strato Designs’ need for parts or other goods from Japan, it might be able to partially or totally offset potential exchange losses/gains from export sales with balancing gains/losses from import purchases at the same time.

5. Strato Designs could make contracts or purchase options only when it believes that the yen will become weaker. When it believes that the yen will become stronger, it could simply wait to sell the yen when received, thereby making an additional profit.

6. Strato Designs could simply not take any advance action, accepting exchange losses or gains as they might occur.

From these possible models, Strato Designs has to decide upon a specific system to use.

Questions

1. Are the Japanese customers of Strato Designs likely to be willing to accept price quotations in dollars? Discuss.

2. What should be the company’s objective in managing the exchange rate situation?

3. What model or system would you recommend that Strato Designs use? Defend your choice!

4. Is your choice in Question 3 something that the company should do for all the foreign currencies that it might have to manage or only for the Japanese yen? Explain.