Merton Electronics – Currency Risk Exposure (Case Study)

Merton Electronics is a company in the United States that imports from both Japanese and Taiwanese suppliers, to then be distributed nationally. Both suppliers invoice in their local currencies (Japanese Yen and Taiwanese Dollars, respectively). Since its founding in 1950 by Thomas Merton, Merton Electronics has become a major manufacturer of electrical and electronic products for the consumer market and institutional market. Over the years, the company added to its lineup of electrical furniture, recordings, CDs and cassettes.

In 1980, Merton Electronics began to expand its production line by importing Japanese electronics. Four years later, the company entered into an exclusive import deal with Taiwan's Goldstone Corporation, another major television and electrical furniture company. In the early 1990s, the company entered the personal computer (PC) market by distributing hardware and software products and became the national distributor of Fuji Electronics, Japan's major PC manufacturer.

Patricia Merton, the chairman and major shareholder of Merton Electronics, is disappointed with her company's performance over the past year. The company’s sales increased by 12% more compared to the previous year, close to budget, but indicating a slow pace compared to the previous 3 years. At the same time, the income in 1997 decreased by 40%, reflecting the increasing difficulty faced by her company in economic situations. Patricia Merton had worked in Merton Electronics for two years when her father Thomas Merton died in 1991. Since then, she took her father’s leadership and continued to lead. Together with his mother, she controls 65% of the company's shares. The remaining shares are held by his father's brothers, family and former employees.

There is one thing that keeps bothering Patricia which is the volatility of the yen and the Taiwan dollar. More than half of the furniture sold in the range of PC, TV, VCR and Hifi products are imported from Japanese suppliers. From a volume of $20 million two years earlier, yen-dominated purchases totaled $27 million over the past 12 months. Another annual purchase is $4 million from a Taiwanese supplier. For Merton's Japanese supplier Fuji Electronics, it is customary to insist on invoices in yen. Meanwhile, according to the initial agreement, Goldstone Corporation made an invoice in US dollars. In 1998, the company was told that the Taiwan dollar used.

When an order is placed, an Asian supplier ships the goods by air cargo within 60 days in many cases. Such payment is 30 days from the end of the month of delivery, therefore the value of goods Y284 million shipped in January 1998 will be paid at the end of February. Two years earlier, near the end of January 1996, due to the falling margins partly owing to the effect of rising exchange rates, Patricia Merton asked her general manager, Charles Brown, to collect monthly purchase volume data from Japanese suppliers as well as the yen-dollar exchange rate. The data that Brown collects is surprising. The effect of the yen's appreciation on the dollar through the summer of 1995 indicated that purchases during that given period cost more in dollars than if the exchange rate had been stable. During the first 4 months of 1995, the increase in the yen amounted to a total of $1.1 million dollars in purchase costs. Data shows that between July and December 1995, a stronger dollar yielded $1.4 million.

At this stage, her bankers argued that Merton faces serious financial risks. She was further reminded that since Merton Electronics imports more products from Japan than its main competitors, thus, its profit margins are likely to become much more sensitive to the value of the yen than before. In this case, the bankers advised Patricia to avoid buying the yen. Now after two years, Patricia Merton suggested that it's about time to review her policies. Again, she asked her bankers to examine their experiences last year in January 1997. The new analysis offered by her bankers seemed very different this time from the previous one. Although the yen remains volatile, it has been weak against the dollar during that period. The cost of purchasing the yen was about $25.5 million during 1997. If the purchases were not stopped, the dollar cost would be about $24.6 million, with a difference of nearly $900,000.

As a result, according to her bankers, there are two basic options when it comes to limiting. She could choose to “lock in” an exchange rate which was close to the prevailing spot rate, or she could opt to use a contract option that would set an upper limit on the cost of the yen, but allow her to get the lower yen profit which can occur at the time when the invoice must be paid. Lock in an exchange rate means that the future price of a foreign currency (future spot rate) is determined and enforced today. In other words, the cap is expected with a stronger yen. This type of restriction guarantees that regardless of the future spot value, the effective price paid for the yen is the one agreed at that time. After all, there are three practical ways to lock in exchange rates, in which it can be done by forward contracts, money market transactions, and currency futures contracts.

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