1) Tiffany & Co. now directly manages its inventory and operations in Japan instead of working through a distributor, exposing it to exchange rate risk between the yen and dollar. 2) To hedge this risk, Tiffany considers forward contracts or put options on the yen. A 3-month put option with a 93.5 yen strike price traded at a 2.06 premium is recommended. 3) This option provides downside protection if the yen weakens below 93.5 yen, while allowing Tiffany to benefit if it strengthens without obligation like a forward contract.

1. SITUATIONAL ANALYSIS:
In July 1993 Tiffany & Company made a new retailing agreement with its Japanese
distributor Mitsukoshi Ltd. Under new agreement tiffany & co. is responsible for
operations in Japan, now it’s the responsibility of tiffany to manage the millions of
inventory. Previously tiffany sold its inventory to independent distributors Mitsukoshi on
wholesale basis and then Mitsukoshi resale it in Japanese market on retail basis. Since
revenue of tiffany was realized in dollar and fluctuations in yen/dollar did not affects the
tiffany’s expected cash flow. Instead Mitsukoshi bore the risk of yen/dollar exchange
rate fluctuations.
Now tiffany faces both opportunities and risk as well. As Japanese market is large and
growing market that will increases the sales and profits with greater control over retail
prices. But now tiffany has to bear the exchange rate risk that previously borne by
Mitsukoshi.
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 inflows. But there are some
market insights that yen will overvalue and crash suddenly.
HEDGING THE RISK:
To reduce exchange rate risk on its yen cash flows, Tiffany has two alternatives:
1) To enter 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 106.355yen per dollar and three month forward is
available at 106.330yen per dollar. No transaction cost is involved in this
contract.
2) To buy 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 option is available at price 1.26 with strike price of 94.0(that
means you will sell 106.3yen for 1 dollar) and another one month put option at
strike price 93.5 is sold at 1.22 premium, three month put option is available at
2.06 with strike price of 93.5.

2. RECOMMENDATION TO TIFFANY:
From historical data 1983 to 1993 it is evident that the yen/dollar exchange rate could
be quite volatile on a year-to-year and even month-to-month basis and the facts
regarding the overvaluation of the yen against the dollar is not certain, so there is still
some uncertainty about the yen crashing. Thus, a three month put option at strike price
93.5(0.00935) for 2.06 (0.000206) would be more appropriate for tiffany.
For suppose if market spot exchange rate goes down below 93.5 then option will be
exercized at 93.5 and tiffany will gain after deducting the premium price from the strike
price. At 93.5 rate means tiffany will sell 106.97 yen for 1 dollar.
Equation:
(K-S, O)
= (93.5- 90, 0)
= (3.5, 0) this is total pay off, now deduct the premium
Profit: 3.5-2.06= 1.44 is the profit from this hedging strategy
Option is exercized.
And in another situation if market spot exchange rate continue to increases and it is
higher than strike price then tiffany will again gain from this situation by not
exercizing the option, their loss is just premium that is paid and it is limited. But will
gain from upside profit potentials.
Equation:
(K-S, O)
= (93.5- 95, 0)
= (-1.5, 0)
In this situation option is not exercized.
Option gives the right to option buyer at cost of premium where as in forward contract
it is obligatory for both parties at no cost. For suppose tiffany enter into 3 month
forward contract at 106.330 yen per dollar and at expiration in September the rates
goes down now in spot it is available at 102 yen per dollar but according to forward
contract its obligatory for tiffany to sell at 106.33, that means tiffany will not gain from
this opportunity.