One of the world's largest airlines, Japan Airlines (JAL), is also one of the best customers of Boeing, the world's biggest manufacturer of commercial airplanes. Every year JAL spends about $800 million to purchase aircraft from Boeing. Boeing aircraft are priced in US dollars, with prices ranging from about $35 million for a 737 to $160 million for a top-of-the-line 747-400. JAL orders an aircraft two to six years before the plane is actually needed. JAL normally pays Boeing a 10 percent deposit when ordering an aircraft, and the bulk of the payment is made when the aircraft is delivered.
The long lag between placing an order and making a final payment presents a conundrum for JAL. Most of JAL's revenues are in Japanese yen, not US dollars. JAL must change its yen into dollars to pay Boeing. In the interval between placing an order and making final payment, the value of the Japanese yen against the US dollar may change. This can increase or decrease the cost of an aircraft when calculated in yen. Consider an order placed in 1985 for a 747 aircraft that was to be delivered in 1990. In 1985 the dollar value of this order was $100 million. The prevailing exchange rate in 1985 was $1 = ¥240 (i.e., one dollar was worth 240 yen), so the price of the 747 in yen was ¥2.4 billion. By 1990 when final payment was due, however, the dollarbyen exchange rate might have changed. For example, the dollarbyen exchange rate might be $1 = ¥300, and the price of the 747 in yen would have gone from ¥2.4 billion to ¥3.0 billion, an increase of 25 percent. Or the yen might have risen in value against the dollar to $1 = ¥200. If this had occurred, the yen price of the 747 would have fallen 16.7 percent to ¥2.0 billion.
In 1985 JAL has no way of knowing what the value of the yen will be against the dollar by 1990. However, JAL can enter into a contract with foreign exchange traders in 1985 to purchase dollars in 1990
based on those traders' assessment of what they think the dollar-yen exchange rate will be in 1990. This is called entering into a forward exchange contract and it allows JAL to know in 1985 what it will have to pay for the 747 in 1990. For example, if the value of the yen was expected to increase against the dollar between 1985 and 1990, foreign exchange traders might have offered a forward exchange contract that allowed JAL to purchase dollars at a rate of $1 = ¥185 in 1990, instead of the $1 = ¥240 rate that prevailed in 1985. At this forward exchange rate, the 747 would only cost ¥1.85 billion, a 23 percent saving over the yen price implied by the 1985 exchange rate.
JAL was confronted with just this scenario in 1985. At that time JAL entered into a 10-year forward exchange contract with a total value of about $3.6 billion. This contract gave JAL the right to buy US dollars from a consortium of foreign exchange traders at various points during the next ten years for an average exchange rate of $1 = ¥185. To JAL this looked like a great deal given the 1985 exchange rate of $1 = ¥240. However, by September 1994 when the bulk of the contract had been executed, it no longer looked like a good deal. To everyone's surprise, the value of the yen had surged against the dollar. By 1992 the exchange rate stood at $1 = ¥120, and by 1994 it was $1 = ¥99. Unfortunately, JAL could not take advantage of this more favorable exchange rate. Instead, JAL was bound by the terms of the contract to purchase dollars at the contract rate of $1 = ¥185, a rate that by 1994 looked outrageously expensive. This misjudgment cost JAL dearly. In 1994 JAL was paying 86 percent more than it needed to for each Boeing aircraft bought with dollars purchased via the forward exchange contract! In October 1994 JAL admitted that in its most recent financial year the loss from this misjudgment amounted to $450 million, or ¥45 billion. Foreign exchange traders speculated that JAL had probably lost of total of ¥155 billion ($1.5 billion) on this contract since 1988.
Source:Global Business Today, Second Edition Charles W. L. Hill
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