Currency Risk Management Strategies for Contracting with Japanese Suppliers

INTRODUCTION The dollar volume of U.S. imports has been increasing steadily for years. These increases have continued to occur in spite of public statements exhorting people to "buy American" and despite various economic downturns. For example, the U.S. Department of Commerce estimates that in 1990 the value of U.S. imports was $495 billion.|1~ This was the largest import volume in American history. Even the recession of 1991, the worst since World War II, had little impact on import volumes. The value of U.S. imports in 1991 was estimated by the commerce department to be $488 billion, only a 1.4 percent decrease from the previous year.|2~ Data from the first five months of 1992 show import volumes to be accumulating at another record pace. Not only are the dollar volumes of imports increasing, but more U.S. firms are purchasing goods from foreign sources. As firms place a strategic emphasis on cost reductions|3~ and purchased components and materials increase as a percentage of company sales,|4~ the effective management of foreign exchange will grow in importance. Research has demonstrated that fluctuations in currency values can erode the profitability of established products and markets when firms rely on imported materials to produce those products.|5~ Until the development of an international currency, the majority of international transactions will be exposed to currency changes. Currency exchange rate fluctuations will affect the prices paid, resulting in prices other than originally anticipated. Therefore, it is vital that a buyer in the international marketplace understand currency fluctuations and the underlying causes of these trends.|6~ For these reasons, academics and practitioners have recognized that the management of foreign exchange risk presents a challenging opportunity for cost reduction for firms that engage in foreign sourcing.|7~ Previous research has shown that there are three major approaches to foreign exchange risk management used by U.S. importers: (1) a "do nothing" approach, (2) a "passive" approach, and (3) an "active" approach.|8~ For an importer, a "do nothing" strategy converts all foreign currency cash outflows in the spot market as they occur. A "passive" approach is one which either (1) exchanges all anticipated outflows of foreign currency for domestic currency cash outflows in the forward or futures markets, thereby hedging all foreign exchange positions, (2) negotiates all sourcing contracts to require payment in U.S. dollars, thereby forcing the supplier to assume the foreign exchange risk, or (3) incorporates a risk sharing contractual agreement. ln contrast, an "active" approach is one in which the importing firm selectively hedges its foreign exchange rate positions based on exchange rate forecast information. This means that the firm may intentionally assume open positions in foreign exchange markets if it anticipates a favorable movement in the exchange rate. The primary purpose of the research reported in this article is to examine the performance of various approaches for managing foreign exchange risk. The study focuses on procurement contracts between U.S. and Japanese firms. U.S. and Japanese transactions were selected for examination because of the increasing importance of Japanese imports to the U.S. economy, the frequent use of the Japanese yen as a currency medium of payment, and the growing number of Japanese and American corporate alliances. Various strategies for foreign exchange management are examined using a simulation methodology. Eight simulation experiments were conducted, corresponding to four different exchange rate scenarios and two contract horizons, three months and six months, respectively. The simulation experiments encompassed thousands of U.S. and Japanese sourcing transactions over the period from January 1986 to December 1990. The first two experiments spanned a time period during which the U.S. dollar decreased in value relative to the Japanese yen. …