Foreign Exchange Hedging Strategies at General Motors

Case Study Solution

Agenda 1. What kinds of risks do FX pose for multinationals? 2. How should a MNC design a risk management policy for FX? 3. How would you evaluate GMs hedging policy? 4. Why is the CAD exposure so troubling? 5. How do you trade off options and forwards? 6. How is GM exposed to the yen? 2

Why do companies hedge?

To reduce transaction costs.
Since individual investors can hedge on their own, why should a firm do so? A firm can likely hedge more efficiently than an individual investor

To provide for future investment needs To manage earnings To speculate To make evaluating a companys operations easier To make the comparison of the foreign subsidiary operations easier
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What risks do multinationals face from FX? 1. Transactional exposures

Arise from real transactions such as debt and A/R Affect income statement

2. Translational exposures

Not economic one Affect balance sheet

3. Operational exposures

Real and economic Indirectly arise from competitive interactions

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What questions must an FX hedging policy of GM address?

What to hedge? Transactional exposures only and only those with an implied risk over $10 million (over $5 million for especially volatile currencies) How much to hedge? How to hedge? Where to hedge? 50% ration; passive Forwards (0-6) and options (6-12) Regionally

When to deviate? Try to stay passive; hedging decisions that do not follow the policy require approval What is the difference between active and passive hedging? Shapiro: Unknown cash flow should use option
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FX exposures to GM
1. CAD
Transactional and translational exposures

2. Argentina peso
How to deal with the widely-anticipated evaluation of the peso

3. Yen
Operating exposure
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GMs Policy on how much to hedge

GM forecasts operating exposures for all its regions on a monthly basis. The riskiness of these exposures = net(regional) exposure * annual volatility of the currency pair (%) If the result > $10 million, GM hedges 50% of the exposure.
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How much to hedge?

GMs North American region had a forecast euro exposure of $400 million, and the annual volatility of the U.S. dollar euro exchange was 12% The implied riskiness of the exposure was $48 million. GM hedged $200 million of its euro exposure
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Should GM hedge the amount at risk, of $48 million or $200 million (50% of the total euro exposure)?
48 million implied risk is calculated simply to determine if GM should hedge. We hedge the underlying risk.

How much to hedge?

The value of our car is $30,000 and there is a 5% probability of accident The expected outcome of accident is losing $1,500 How much will you buy the insurance? We will buy the insurance for the full value of the car, or $30,000, not $1,500.

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Should GM hedge on a worldwide or regional basis?

Pro: GM operates in so many countries, so the exposures of different subsidiaries would often cancel out Save costs Con: GMs subsidiaries have their own objectives.

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Why do GM requires approval for deviations from its hedging policy?

GM used to actively manage its myriad currency risks. Active FX management demands considerable manpower and management attention. GM did not consider that active management provided significantly better results.
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Does GMs policy on how much to hedge make sense? Why not 40% or 100%?
Hedge 50% of FX exposures - safe The mid-point a prudent choice Easy to explain to shareholders Maybe a legal reason Expensive to hedge 100%
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Canadian Dollar Exposure

GM is short about CAD 1.7 billion It has to pay Canadian suppliers for materials and services. A transactional exposure. According to GMs hedging policy, 50% of this exposure should be hedged.
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Why did managers request to hedge 75% of this exposure?

The concern is that GM Canadas balance sheet includes significant pension obligations. A total balance sheet exposure is CAD 2.1 billion GMs hedging policy excludes hedging such translational exposure. In effect, the translational exposure would be hedged by increasing the hedge on the transactional exposure.

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How big a difference is this to GM?

HEDGE RATIO SCENARIO - CAD is: Commercial exposure 12-month rolling net receivables forecast (CAD) Notional hedge amount at hedge ratio (CAD) Net cash (CAD) FX hedge put in place (CAD) Net FX exposure (CAD) GM Worldwide US GAPP FX exposure GM Worldwide US GAPP FX exposure (CAD) Earnings impact on GM Worldwide GM Worldwide FX gain/(loss) FX gain/(loss) on hedges GM Worldwide pre-tax income impact GM Worldwide after-tax (35%) income impact Scenario CAD/USD FX rate Range CAD/USD FX rate - sensitivity 50.0% 3.1% Stronger 3.1% Weaker 75.0% 3.1% Stronger 3.1% Weaker (1,682) (841) 841 (841) (1,682) (841) 841 (841) (1,682) (1,261) 1,261 (420) (1,682) (1,261) 1,261 (420)

(2,143)

(2,143)

(2,143)

(2,143)

(43.4) 17.0 (26.4) (17.2)

40.8 (16.0) 24.8 16.1

(43.4) 25.6 (17.9) (11.6)

40.8 (24.0) 16.8 10.9

1.5780 (3.1%) 1.5291

1.5780 3.1% 1.6269

1.5780 (3.1%) 1.5291

1.5780 3.1% 1.6269

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Why is the CAD exposure so problematic? Transactional Short CAD 1.7bn Translational Short CAD 2.1bn What are they doing?

Hedging a translational exposure through increased transactional hedges

How should GM use forward and options to hedge?

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How can forwards and options be compared for hedging the CAD?
2,000,000 Exp + Fwd 1,500,000 Exp + Opt Exposure 1,000,000

500,000

(500,000)

(1,000,000)

(1,500,000)

(2,000,000) 14000

14500

1 5000

1 5500

16000

16500

17000

17500

1 8000

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What about the ARS exposure? What can you do about that now?
What are the forward rates telling you? What does this mean for how expensive hedging is by this time?
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How and why is the yen a competitive exposure? Tracing the chain through all the way from a yen devaluation to GM PV consequences

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But how does the yen exposure fit in with other yen exposures? These exposures must be combined relative to other exposures

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What else can GM do about the yen exposure?

1. Lower its own US prices domestically

To combat some loss in market share Get same benefits as Japanese automakers buy plants in Japan

2. Change sourcing

3. Borrow yen and use yen to finance its lower price strategy

Might be easier than buying a Japanese plant

4. Increase investments in Japanese companies

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What other companies would you expect competitive exposures to be big in?
Boeing & Airbus; Harley-Davidson Steel How could we analyze GMs competitive exposure to the yen more rigorously?
Monthly returns of GM = a + (0.987 *S&P500 returns)
GM moves in line with market

Monthly returns of GM = a + 0.4 (returns of $/yen)

When we see 10% devaluation in USD, GM stock return increase 4%.

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Source: Rohan Williamson, 2001, Exchange rate exposure and competition: evidence from the automative industry, Journal of Financial Economics 59, 453-475

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Source: Rohan Williamson, 2001, Exchange rate exposure and competition: evidence from the automative industry, Journal of Financial Economics 59, 453-475

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Source: Rohan Williamson, 2001, Exchange rate exposure and competition: evidence from the automative industry, Journal of Financial Economics 59, 453-475

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Why has yen become more important?

Closer integration of product market

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