As Toyota is a multinational corporation, Toyota has faced foreign currency exposures related to buying, selling and financing in currencies in different foreign countries. The foreign currency risk which exposed by is related to future earnings, assets and liabilities. The reasons are due to operating cash flows and various other financial instruments which are denominated in foreign currencies. Due to Toyota most profitable market is still in America and Euro countries, U.S. dollar and the euro are the impact of the foreign exchange risk.
Toyota employs derivatives financial instruments, including forward contracts and foreign currency options to manage its exposure to fluctuation in foreign currency exchange rates. They monitors and manages these financial exposures as an integral part of its overall risk management program which recognizes the unpredictability of financial markets and seeks to reduce the potentially adverse effects on Toyota's operating results. Toyota's portfolio of derivative financial instruments consists of forward foreign currency exchange contracts, foreign currency options, interest rate swaps, interest rate currency swap agreements and interest rate options to manage their global risk.
"Toyota uses a value-at-risk analysis ("VAR") to evaluate its exposure to changes in foreign exchange currency rates. The value-at-risk of the combined foreign exchange position represents a potential loss in pre-tax earnings. The value-at-risk was estimated by using a variance/ covariance model and assumed a 95% confidence level on the realization date and a 10-dayholding period. Toyota changed the model used for calculation of value-at-risk from "variance/covariance" method to "Monte Carlo Simulation" method for more effectively to the risk management purposes. By using this value-at-risk analysis (VAR), the company able to manage their global risk effectively. For instance, the VAR of the combined foreign exchange position showed a loss in pre-tax earnings that was estimated to be 114.1 billion as of March 31, 2009 and 148.9 billion as of March 31, 2010.
Forward contract is an agreement to exchange currencies of different countries at a specific future date and at a specific forward rate. Changes in foreign exchange rate affect Toyota's revenue, gross margins, operating costs, operating income, net income and retained earnings. Toyota's use of forward exchange rate contracts and currency options is to hedge foreign exchange risk associated with trade receivables denominated primarily in U.S. dollars. Toyota also engages in foreign currency settlements with domestic counter parties. The company enters into forward contracts and purchases currency options to hedge certain portions of forecasted cash flows denominated in foreign currencies. Additionally, the Company enters into forward exchange contracts to offset the earnings impact relating to exchange rate fluctuations on certain monetary assets and liabilities. The Company enters into forward exchange contracts as hedges of net investments in international operations. This reduces foreign exchange risk and transaction costs in those settlements by handling receipts in the foreign currencies in which they are denominated.
Natural hedging is to manage an anticipated exposure to a particular currency by acquiring a debt denominated in that currency. Thus if a firm has a long term inflow in one currency, the firm can acquire an outflow in the form of a loan in the same currency and use the inflow to service the debt. Since Toyota's main markets are the USA and Europe, it can take out loans in Euro or dollars and use the proceeds from its operations to pay for the loan. Toyota will then not have to bother about the exchange rate fluctuation, as it will be paying the loan from proceeds generated from local operations. Toyota is also asking its British suppliers to bill them in the Euro so as to reduce the risk. This is effective in eliminating currency exposed when the exposure cash flow is relatively constant and predictable over time.
Netting intercompany transfers is another form of international cash management strategy that Toyota can employ. It requires a high degree of centralization. The basis of netting is that, within a closed group of related companies, total payables will always equal total receivables. Netting is useful primarily when a large number of separate foreign exchange transaction occur between subsidiaries. Thus instead of Toyota paying monies owed to and by each subsidiary, the subsidiaries can net off each other's debt and thereby not deal in the foreign exchange market. Toyota should establish an in house netting centre in order to reduce the bank transaction cost, such as spread between foreign exchange bids and ask quotations and transfer fees. The exposure that remains the net payments to payees and payees can then be hedged in the forward market if desired. The advantages of netting are reduction in foreign exchange conversion fees and funds transfer fees as commissions on foreign exchange transactions and funds transfer are drastically reduced.
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