Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures

The Ministry of education and science of the Russian Federation

Federal State Budgetary Educational Institution of Higher Professional

Education

Plekhanov Russian University of Economics

Faculty of Finance, Department of Risk Management, Insurance and Securities

Subject: Financial risk management

Case 1 analysis: Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures

Prepared by students of 17OMA-01/15ФА group

Of intramural Master’s program

Of Faculty of Finance

First year

Alkader N.,

Coric O.,

Jawhara W.,

Levitsky O.,

Usacheva P.

Academic advisor: Finogenova Y.Y.

Moscow - 2016

Introduction and Problem Statement:

This report is based on a practical scenario solution of General Motors. General Motors was the world’s largest automaker, with 15.1% worldwide market share it had been the world’s sales leader since 1931. Founded in 1908, GM had manufacturing operations in more than 30 countries, and its vehicles were sold in approximately 200 countries. In addition to vehicles, other major product lines included

• financial services for automotive, mortgage, and business financing, and insurance services through General Motors Acceptance Corporation (GMAC),
• satellite television and commercial satellite services through Hughes Electronics,
• locomotives and heavy duty transmissions through GM Locomotive Group and Allison Transmission Division.

GM traded on the New York Stock Exchange and was a component of the Dow Jones Industrial Average.

The case study addressed company’s exposure to the foreign risk due to its presence at a number of geographical locations and transactions in different foreign currencies. Current corporate hedging policy consists of hedging 50% of all significant foreign exchange commercial exposures (cash flows associated with the ongoing business such as receivables and payables) on a regional level and is aimed at meeting three primary objectives:  

• reduce cash flow and earnings volatility,
• minimize the management time and costs dedicated to global FX management,
• align FX management in a manner consistent with how GM operates its automotive business.

However there are two special issues that were addressed in the case study. The problems require thorough consideration as the existing policy is not very much appropriate to these two matters.

First problem is the company’s exposure to the foreign exchange risk arising from Canadian subsidiary which has the primary operating currency USD (due to very large U.S. dollar-denominated flows). Since GM-Canada’s functional currency was the U.S. dollar, its exposure to the Canadian dollar was recognized as a foreign currency exposure. The income statement impact arose from gains and losses on both the CAD-denominated cash flows and on the balance sheet CAD net monetary liability position. Both exposures were equivalent to short positions in the Canadian dollar. The net payable cash flow exposure resulted largely from payments due to Canadian suppliers, and the size of the net monetary liability stemmed mainly from future pension and postretirement benefit obligations to employees in Canada.

There are two types of risks that GM faces in this situation: one is translation risk and the other one is transaction risk. GM’s passive policy which assumed hedging cash flows (transaction exposures) only and ignoring balance sheet exposures (translation exposures) called for hedging 50% of the CAD 1.7 billion cash flow exposure only, leaving unhedged a CAD 2.1 billion net monetary liability: such a large CAD exposure could significantly impact GM’s year-end financial results.

The company is looking at different hedging strategies to mitigate the risks, dealing with the matter exceptionally from the company’s policy. In order to solve the problem, different instruments (options and forward contracts) should be analyzed for different level of hedge ratio (standard 50% and the maximum allowed under GM policy—75%) plus favorable and unfavorable scenarios. Translation risks should also be discussed and impact of them on income statement should be estimated.

The second problem is the management major translation risk arising in Argentina subsidiary due to recent major devaluation in the local currency. With $16.5 billion of foreign loans coming due in 2002, Argentina was now at serious risk of defaulting on its debt. Credit analysts at Standard & Poor’s and Moody’s had downgraded Argentina to six and seven grades below investment grade, respectively. A default would very likely be accompanied by a large devaluation. In order to control historic inflationary tendencies, the government maintained a peg to the U.S. dollar at USD:ARS as 1:1.

Having a 300 USD million exposure, GM needs to evaluate a strategy to deal with this long term risk and mitigate the impact of a likely devaluation. The company should consider how a potential devaluation of the peso against the dollar from 1:1 to 2:1 would impact GM Argentina. This suggests evaluating how costly it would be to hedge the ARS exposure in the financial markets, reviewing the market for different hedging instruments (forwards and options) on the ARS based on rolling over shorter term contracts or purchasing year-long contracts.

Analysis:

Canada:

Because GM’s hedging operations constituted a substantial volume of currency trading, GM was concerned with executing its hedging policies in a cost efficient manner. Therefore the objective of the calculations was to compare forward contracts and options on a cost basis. While both are popular hedging instruments, a forward contract was always a zero cost contract on the trade date, and buying an option involved paying a premium.

Analysis of the two strategies required defining how the strategies would have fared at the different possible exchange rates that might prevail at the future date (the date of the exposure to hedge). In order to do that, options and forward contracts were analyzed from the perspective of hedging an outright exposure of 20 million CAD position using both standard 50% and 75% hedge ratios in a range of 1,4 to 1,8 CAD/USD future spot rates with 1,5667 as a forward(strike) price. A premium cost for the option was determined as 1,45% of the notional hedge amount.