Caseroblem 6 Mercks Use of Currency Options

The effect of foreign-currency fluctuations on a company depends on a company's business structure, its industry profile, and its competitive environment. This case recounts how Merck assessed its foreign-exchange exposure and decided to hedge those exposures.

In 2001, Merck celebrated its 110th anniversary in discovering, developing, producing, and distributing human and animal health pharmaceutical products. Today, the company does business in more than 100 countries around the world. Thus, it is part of an industry that makes its products available for the prevention, relief, and cure of disease throughout the world.

Approximately 50 percent of worldwide sales for Merck come from foreign operations. International earnings assets for the company account for 40 percent of its total earnings assets. The pharmaceutical industry is highly competitive, with no company holding more than 5 percent of the worldwide market. Merck ranks first in pharmaceutical sales in the world, but has slightly less than 5 percent market share worldwide.

As Merck became increasingly global, it continued to establish and enhance strategic alliances here in the USA and abroad, in order to discover, develop, and market innovative products. Moreover, Merck understands that future competition will be more global in nature. To prepare its managers for this broader challenge, Merck continues to expand the international nature of its management training. Programs focus increasingly on international issues such as foreign-exchange risk management, and training program participants reflect the worldwide nature of the company's businesses. For example, the senior-level managers who attended its Executive Development Programs in recent years came from 30 countries.

US pharmaceutical companies have expanded into foreign markets significantly more than have their counterparts in other industries, because they have to fund high risk and growing research expenditures. These companies also differ in their method of doing business overseas. Although many US exporters bill their customers in US dollars, most pharmaceutical companies bill their customers in local currencies. Consequently, the impact of exchange rate volatility tends to be more immediate and direct.

Foreign subsidiaries of pharmaceutical companies are typically importers of product at some stage of production. And these subsidiaries are responsible for completing, marketing, and distributing the product within the country of incorporation. Sales are denominated in local currency, but costs are denominated in a combination of local currency and the parent-country currency.

The Identification and Measurement of Exchange Exposure

The Company

Every company faces exposure to foreign-exchange risk as soon as it chooses to maintain a physical presence in a foreign country. Foreign-exchange fluctuations can affect a US

multinational company in three ways. First, the dollar value of net assets held in foreign currencies may be changed. This type of exposure is called translation or accounting exposure; it measures the effect of an exchange rate change on published financial statements of a firm. Second, the expected results of outstanding transactions, such as accounts receivable and/or accounts payable, may be changed. This sort of exposure is known as transaction exposure; it measures the effect of an exchange rate change on outstanding obligations that existed before exchange rates changed but were settled after the exchange rate change. The third type of exposure is referred to as economic exposure; it involves the potential effects of exchange rate changes on all facets of a firm's operations: product market, factor market, and capital market. Economic exposure consists of future revenue exposure and competitive exposure. Future revenue exposure is the possibility that the dollar value of future revenues expected to be earned overseas in foreign currencies may be changed. Competitive exposure is the possibility that a company's competitive position may be changed - for example, a competitor whose costs are denominated in a weak currency will have greater pricing flexibility and thus a potential competitive advantage.

Competitive exposure has been the subject of recent academic study on exchange risk management. Such exposures are best exemplified by the adverse effect of the strong dollar on the competitive position of US industry in the early 1980s. This was true not only in export markets but also in the US domestic market, where the strengthening US dollar gave Japanese and European-based manufacturers a large competitive advantage in dollar terms over domestic US producers.

With its significant presence worldwide, Merck has exposures in approximately 40 currencies. As a first step in assessing the effect of exchange rate movements on revenues and net income, Merck constructed a sales index that measures the relative strength of the dollar against a basket of currencies, weighted by the size of sales in those countries. The company used 1978 as the base year of its sales index. When the index is above 100 percent, foreign currencies have strengthened against the dollar, thereby indicating a positive exchange effect on dollar revenues (exchange gains). When the index is below 100 percent, the dollar has strengthened against the foreign currencies, thereby resulting in a negative exchange impact on dollar revenues (exchange losses). Merck evaluated its sales index from 1972 to 1988 and found that it had significant exchange exposure of its net overseas revenues.

Given the significant exchange exposure of its overseas revenues, Merck then decided to review its global allocation of resources across currencies; the main purpose of this review was to determine the extent to which revenues and costs were matched in individual currencies. The review revealed that the distribution of the company's assets differs somewhat from the sales mix, primarily because of the concentration of research, manufacturing, and headquarters operations in the USA.

Hedging Exposures with Financial Instruments

Having concluded that a diversified strategy (resource deployment) was not an appropriate way for Merck to address exchange risk, it considered the alternative of financial hedging. Thinking through this alternative involved the following five steps: (1) projecting exchange rate volatility; (2) assessing the impact of the 5-year strategic plan; (3) deciding on hedging the exposure; (4) selecting the appropriate financial instruments; and (5) constructing a hedging program. Based on this five-step process, Merck decided to choose currency options as its risk management tool.

Identifying a company's exchange risk and deciding what action should be taken require extensive analysis. Merck management felt that, as a result of this analysis of its currency exposures, it had developed an appropriate financial hedging plan - one that insures against potentially damaging effects of currency volatility on the company's strategic plan.

Apparently, this hedging strategy has worked well for Merck since 1989 (Schlesinger 2000). Because Merck does about half its business overseas, the dollar surge in the 1980s "really put a crimp in the performance of the company" as the dollar value of foreign revenue fell, recalls Chief Financial Officer Judy Lewent. In response, the company was repeatedly forced into sudden cutbacks in planned research and development spending and capital investments. Beginning in 1989, Merck started hedging against foreign-exchange movements, a practice honed throughout the decade. Thus, even as the dollar surged against the euro last year, Ms Lewent says, "we were able to go through the year and continue our budget commitments to our operating people."

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