Use of Derivatives in Toyota Essay Example

currency swaps, and interest rate options. Interest rate currency swaps involve combining currency swaps with interest rate swaps, with Toyota using this strategy to swap a fixed debt denominated in US dollars for a floating rate debt denominated in Euro (Hull,J,C,p. 707). Interest rate options are options on financial assets that are affected by changing interest rates, and Toyota utilizes them to manage interest rate risk effectively (Hull,J,C,p. 707). Overall, Toyota employs interest rate swaps, interest rate currency swap agreements, and interest rate options to manage its risks associated with interest rates.

Toyota implements various strategies to reduce the risk associated with interest rate expenses. In fiscal year 2007, Toyota predicted a loss of approximately ? 99.5 billion due to a 100 basis points increase in interest rates. In fiscal year 2008, the estimated loss amounted to ? 110.6 billion (Toyota, 2008).

The interest expense on pay float swaps decreased in fiscal 2008 compared to 2007 due to significant declines in the 3-month LIBOR rates. This resulted in a lower interest expense on debt, net of pay float swaps for fiscal 2008. The total interest expense for the years 2008, 2007, and 2006 were $2,956, $4,151, and $2,662 respectively (Toyota, 2008). These figures demonstrate a substantial decrease in interest rate expenses in fiscal year 2008, thanks to the effectiveness of Toyota's interest rate derivative strategy. In order to mitigate interest rate risk, Toyota could consider entering into a forward rate agreement. A forward rate agreement is an over-the-counter agreement that allows for the application of certain interest rates to specific principals during a designated future period (Hull, J.C., p.).

100). Future rate agreement *4.

COMMODITY PRICE RISK IN *TOYOTA

Impact

of Commodity P*rice *Risk on operation Commodity price risk is primarily caused by fluctuations in commodity prices. Commodities such as non-ferrous alloys e.

Toyota faces commodity price risk due to variations in the prices of materials like aluminium, palladium, platinum, rhodium, and ferrous alloys used in the production of motor vehicles. This is outlined as the main cause of commodity price risk according to Toyota's 2008 report. Rather than utilizing derivative products for risk management, Toyota manages the price risk associated with sudden increases in materials prices by keeping stock levels at a minimum.

4.3 Evaluating the Effectiveness of Commodity Price Risk Management Strategies:

a) Futures Contracts:

b) Options Contracts: Toyota can also utilize options contracts for commodities involved in its production process. These options grant Toyota the right, but not the obligation, to buy the commodity at a specified future rate. However, one disadvantage of options is their costliness due to the premium they entail.

Toyota has the ability to buy call options because they grant the right to purchase the asset.

EQUITY PRICE RISK IN TOYOTA

The impact of equity price risk on Toyota's operations is currently affecting the funds the company has invested in various market securities, which are vulnerable to price risk (Toyota, 2008). This significant investment exposes Toyota to equity price risk.

Additionally, Toyota does not utilize derivative products to manage this type of risk. The fair value of estimated marketable securities was 1,679.

According to Toyota (2008), the company's investments amounted to 8 billion yen as of 31 March 2007 and 1,177.0 billion yen as of 31 March 2008. Toyota anticipated a decrease in the fair value of these investments by approximately ?168.0

billion in fiscal year 2007 and ?117.7 billion in fiscal year 2008.

COMPARISON OF DERIVATIVES BETWEEN TOYOTA

DERIVATIVE PRODUCT ANALYSIS Note: Interest rate swap is the common derivative product used by Toyota for interest rate risk management.

In 2008, Toyota also utilized an Interest Rate Currency Swap to manage the high volatility in both the exchange rate and interest rate. Additionally, they employed an interest rate cap as a form of insurance against the uncertainty of interest rates.

RECOMMENDATIONS

The annual report for 2008 clearly demonstrates that Toyota's operating profit decreased due to rising production costs caused by the rapid fluctuation in commodity prices of raw materials used in automobile production. We recommend that Toyota explores future contracts and options based on their market forecasts.

Toyota can engage in forward contracts to procure materials such as Palladium and Aluminium for car production. Additionally, derivatives like Futures contracts, Forward contracts, and options can be utilized by Toyota to mitigate equity risk associated with securities.