Introduction
Foreign Exchange movement is one of the major factors to be considered in risk management at the corporate-level strategy of an organization. This report is focused on analyzing the 2009 annual report of IBM to identify the risk exposure of the company in terms of its foreign exchange and the impact of the risks on the values of the company. Also, an analysis of IBM's international operations is carried out to identify the transactions carried out with trading partners, and others in international financial markets and their risk implications. In this report IBM's hedging techniques such as transaction exposure, economic exposure and exposure on translation will be discussed in detail.
Overview of the Company
International Business Machine, IBM is a multinational company and has operations across 170 countries worldwide. IBM is the one of the largest companies in the information technology sector and has been in operations from the 19th century. It is also a major supplier of IT products and services to the world. In 19th century, the merger of Tabulating Machine Company, the International Time Recording company and the Computing Scale Company of America resulted in the establishment of Computing-Tabulating-Recording Company (CTR) on June 16, 1911 (IBM, 2010). The forward thinking culture and practices have well grounded the core values thus making the company one of the leading manufacturers and sellers of Computers and related Hardware and Software. IBM is also a major provider of infrastructure services, outsourcing sources, consulting in areas like mainframe computers and in nanotechnology and hosting services (CrunchBase, 2010).
3. Foreign Exchange Risks involved in IBM
Foreign Exchange Risk is the outcomes that may be profitable or risky due to the foreign exchange movements and in turn have an impact on the company's profits, value and cash flows. Hence in order to reduce the risks involved and make it more profitable for the organisation, the management should control the degree of foreign exchange exposure of the firm (Dumitrescu, 2009). Exchange rate fluctuations can be further classified as exposure due to Transaction, Economy and Translation (Madura, 2009, p. 282). Analyzing IBM's annual report reveals that the firm is exposed to all three types of exposure to exchange rate fluctuations.
Exposure due to Foreign Transactions
A firm's future contracted cash flow transactions in foreign currencies are affected by the exchange rate movements of currencies which in turn affects the MNC's cash flows (Madura, 2009, p.282) (Dumitrescu, 2009). Transaction Exposure is defined as the "sensitivity of the firm's contractual transactions in foreign currencies to exchange rate movements" (Madura, 2009, p.282). It is usually measured by estimating the MNC's net cash flows in each currency and the potential impact of the exposure (Madura, 2009, p.282). A loss of worth $351 million reveals the transaction exposure of IBM in the year 2009.
Exposure due to Economies
Exchange rate movements can affect an organisation's cash flows if transactions were carried out in foreign currencies, revenues were received from foreign customers, or if the firm faces foreign competition. Economic exposure also known as operating exposure is defined as the sensitivity of firm's cash flows to exchange rate movements (Madura, 2009, p.290) (Dumitrescu, 2009). Economic exposure affects the long term cash flows of an organization.
IBM's sensitivity analysis to economic exposure shows that a 10% weaker U.S dollar as of December 31, 2009 would decrease the company's fair value of financial instruments worth $609 million when compared to a decrease of $1007 million at December 31, 2008. The company financial instrumental value will get increase from $609 million to $1007 million if it possesses 10% stronger value of US currency against foreign currency at December31, 2008 (IBM, 2009).
Also, the interest rate risk analysis reveals that a 10% decrease in the interest rates would reduce the fair value of the company's financial instruments of $274 million to $353 million at December 31, 2008 (IBM, 2009). On the contrary, a 10% increase in the interest rate levels would increase the fair value of a firm's financial instruments of $251 million worth when compared with the increase of $327 million at 31 December, 2008 (IBM, 2009).
Exposure due to Currency Translations
The financial statements for an organisation are usually prepared by combining the financial statements of its individual subsidiaries. The financial statement of a subsidiary is represented in the local currency and hence has to be changed to parent currency during consolidation and the exchange rate movements affect the translation process. "The exposure of the MNC's consolidated financial statements to exchange rate fluctuations is known as translation exposure" (Madura, 2009, p.295). The location and amount of business conducted by the MNC in its subsidiaries and the accounting method used plays an important role in determining translation exposure (Dumitrescu, 2009).
The assets and liabilities of IBM's subsidiaries are converted from local currency to U.S dollars at the exchange rate available at end of the year (IBM, 2009). Hence IBM's assets and liabilities have decreased in value as they were translated from local currencies to U.S dollars at the end of December 31, 2009 (IBM, 2009). IBM's revenue decreased by 10.6 percent in the first three quarters of the financial year 2009 while the revenue was increased by 0.8 percent in the last quarter as the company's operations were in foreign currencies than in U.S dollars. (IBM, 2009).
4. International Operations carried out by IBM
Then main operation of IBM is performed from its head quarters located in United States of America. Although the head quarters in US, its most income comes from the world wide operation. It has been estimated that around 65 percent of the income is generated outside of the United States IBM operation. From the 2009 annual report of IBM, it was announced that IBM's revenue is $95.8 billion and the net income generated is $13.4 billion. IBM also possesses a total asset of $109 billion according to the annual report 2009. The main sources for the IBM's international operations are from Asian and European countries (IBM, 2009).
The main strategies followed by companies in their international operation are to reduce the risks caused during the transactions. If these risks are reduced then the companies will maximise its value. But in general most of the companies were not able to reduce the risks during international transactions. In case of IBM, it uses effective strategies to overcome the risks and thus they gained value maximisation in its international operations. It is discussed that the main success of IBM in personal computer industry is because of its strategies in hedging (Mello and Parsons, 2000).
Interaction with Customers, Trading Partners and Suppliers
IBM has set policies and principles in order to minimize the risks from transaction. This procedures in policies will be standard for the all the operation with the IBM's partnering organisations. These procedures not only minimises the transaction risks but also assess the credibility of the partners. As it is very essential to verify the creditworthiness of the international operation as it will be vital factor to IBM in maintaining the currency value of the American dollar. It is also noted as around 33000 suppliers for the IBM and it very important for them to satisfy all the procedures to exist as IBM supplier. The IBM policy and procedures also ensures on corporate social responsibility and the supplier and partnering organisations has to follow these IBM policies (IBM, 2009).
IBM has a high market in the United States operations. As it was already mentioned that the IBM's international operations are the main income of IBM, the main revenue operations sites are in Asia, china and Europe. IBM has many customers in its telecommunication operations across the countries and also has operations its main operation in a famous bank of Austria, thus increasing its value and operations in the European nations. IBM is also going to invest on its growing markets such as India, China, Russia and in some other countries (IBM, 2009).
Implications of Risk Involved
In the Risk implication process, IBM has to face many risks and the risks are given below in detail.
Interest Rate Risks
IBM expects changing in interest rate to change in its market value because of the maturities in debts, increase in interest and interest rate profile. Interest rate can be termed as the change of interest of company in order to maintain the value (Moir, 1999).
Foreign Exchange Rates
Foreign Exchange rates are caused due to changes in the currency value of the local domestic market. IBM maintains a 10 percent US dollar with its foreign currencies for the international transactions (Levi, 2005).
Inflationary Risks
The IBM subsidiary which operates outside of united state has its risk implication as they are working in a high inflationary environment (Levi, 2005).
Other Risks:
Risks related with the receivables, procurement, leased assets residues are considered to be other risks. In such risks, IBM will follow its procedures and policies (IBM, 2009).
5. Hedging Strategies used by IBM
IBM is a country which functions among various different countries around the world. It is one of the finest borrower and lender in the international financial market (IBM, 2009, p.93). Different types of methods are used to hedge foreign exchange risks which are linked with IBM's day to day operations. IBM faces different kind of exposures in the areas of Economic, Translation and Transaction. These three exposures are hedged by the company utilizing derivatives like future & forward contracts, currency & interest-rate swaps. Few other means might also be used depending on the underlying exposure (IBM, 2009, p.93).
Transaction Exposure Hedging
The company uses forward contracts to hedge currency fluctuations. This is forward contracts is performed for vendors, royalties, goods and services in the company's subsidiaries which is outside the united states and with the parent company (IBM, 2009, p.96). Four years is the maximum length of time used by a company for hedging its exposure to the variability in future cash flows. The time duration taken for performing the forward and swap contracts will take less than six months period (IBM, 2009, p.97).
I - Debt Risk Management
The deal which was made between IBM and World Bank helps in identifying the origin of swaps. IBM and World Bank showed the swaps in the market and it helps to grew. The Swap market now deals with trillions of dollars of funds (Jose, 2010). IBM issues debt in the global capital markets.
The main reasons for it are to finance lean and loan portfolio. The company uses Interest-Rate Swaps as a key which results in interest-rate mismatches and also helps bringing down the overall interest cost. This helps the company convert specific fixed-rate debt issuances into variable rate debt which are called fair value hedges in other words and also convert specific variable-rate debt issuances to fixed-rate debt i.e cash flow hedges in other words (IBM, 2009, p.95).
The company employs Cross Currency Swaps to exchange volatility on foreign currency on foreign currency denominated debt. This convert's fixed rate foreign currency's mentioned debt to fixed-rate debt mentioned in the functional currency of the entity which borrows (IBM, 2009, p.94). The total notional amount of cross-currency swaps as at 31, December 2009 was $0.3 billion. These were designated as cash flow hedges of foreign currency denominated debt.
II - Long term transactions
The two main hedging measures the company uses are the foreign exchange contracts and cross-currency interest rate swaps. This helps in maintaining the volatility in stockholder's equity which are often changed due to the foreign exchange currency rates. These exchange rates are in the functional currency of all the subsidiaries of the company with respect to the U.S dollar (IBM, 2009, p.95).
III - Why not options?
Options are not been used as a derivative by the company. This is because the contractual obligations are not being met by the counterparties. In order to avoid this risk, the company can be careful while selecting the financial institutions and these institutions can be selected upon their credit ratings (IBM, 2009, p.94).
Economic Exposure Hedging
Unexpected changes which occur in exchange rate on the firms input and output prices directly lead to Operational exposure. Operational hedges play a better role in managing long-run exposure whereas financial hedges play a better role in managing short-run exposures (Logue, 1995). Most of the MNC's like IBM have another hedging tool i.e the operating flexibility by their foreign network. This exposure because of operating is usually costly for small firms but the cost is lower for IBM Company (Pantzalis, Simkins, & Laux, 2001).
The gross margin risk is related with change in interest rates is mitigated by the combination of the company's Interest rate risk management policy and the Global financing pricing strategy. The company's revenue and the overall profit might get affected because of the Interest rates and country economy (IBM, 2009, p.97).
Translation Exposure Hedging
The company hedges currency risks avoiding risk that is connected with foreign currency translation for all the subsidiaries outside United States and for United States branches that operate in U.S dollars. This is done by connecting prices with contracts to U.S dollars and by going into foreign currency hedge contracts (IBM, 2009, p.56).The translation of foreign currency reaps much benefits and it is reflected in the consolidated statement of stockholders equity.
6. Various Recommendations for IBM
The reassessment of foreign exchange rate derivatives is done by the firms who have an aim to manage the striking increasing risk in currency associating the financial crisis effectively (Holbrook, Wade, & Kirschner, 2009). The recommendations are given below:
It would be better if IBM goes for foreign currency derivatives instead of foreign currency debts as to hedge the foreign exposure IBM uses currency debts and foreign currency derivatives. This makes the short term contract served better in derivatives instead of long term foreign debt (Allayannis & Ofek, 2001).
The company employs Forward Contracts to hedge currency fluctuations instead IBM can go for good credit rated institutions i.e dealers in other words as it saves a huge amount of money to get a good rate sometime.
To overcome the operational exposure or the economic exposure which IBM faces, the operating strategies may be derived that helps IBM to reciprocate the actual or the anticipated exchange rate changes. The operating strategies consist of various market production and market initiatives to overcome this problem.
The company should properly analyze all the alternatives and different scenarios before deciding the method which they are going to use. They should take advice from people like dealers, high reputed banks instead of doing it themselves. This helps them make more in-depth analysis.
Most of the firms use foreign currency derivatives which helps them to protect from exchange rate movements (Allayannis & Ofek, 2001) . They do not do it to speculate in the foreign exchange market. In order to forecast the implication of risks in partnership with CLS, IBM has developed software. IBM can use software like MUREX, CALYPSO to analyze its foreign risk which are quite popular in the market as it is popular for future predictions which are more precise than compared to all the other software in the market.
7. Conclusion
This report clearly brings out the various risks like foreign exchange risk and other risks in international business that are faced by IBM due to its foreign transactions and the various hedging strategies used by them to handle the risks. Though IBM has been successful in handling the risk effectively, there have been some recommendations that would help IBM to successfully carry its operations in the future.
