General Motors Currency Risk Exposure

Li Yi Liao Shin-Wei Peng Yang Tanvi Karambelka

Introduction This presentation deals with General Motors risk management strategies especially concerning currency risk exposures. Roadmap: 1. Necessity for MNCs to hedge currency risk 2. GMs hedge policy 3. CAD Exposure 50% or more? 4. CAD Exposure Forwards or Options? 5. Argentinean Peso Exposure

Why Hedge?
Companies with global operations face three kinds of risks Transactional, Translational, Economic. Foreign exchange rate risk involves the potential for exchange rate changes to harm the financial position of a firm involved in global operations. Failure to hedge may result in cash flow being very volatile. The exchange losses or gains may lend unpredictability to the net income and shareholders equity.

General Motors Risk Management & Hedging Poligy (I)

Functional structure is highly centralized -Market Risk; Counterparty Risk;Corporate Risk -Analyse and research regionally Translation exposures are ignored -Canada, a core supplier of GMs operation in North America -US dollar is the functional currency Passive Hedging is preferred over active management.

General Motors Risk Management & Hedging Poligy (II)

50% forward contracts-Months one through six months and 50% options-months seven through twelve In the combined hedge, the options had to make up 25% of hedge position. Policy is too constricted -The derivatives market is fluid -Rolling forward -Over-or under-hedged

Currency Exposure - Canada

Why Is CAD an issue?
Cash flows Amt ( million)

Inflows
Outflows Total B/S Assets 2,597

11,613
13.294 (1,682) Amt ( million) Liability 4739 (2,143)

Currency Exposure Canada (II)

How much should it HEDGE? Comparison between 50% & 75% hedge ratio

Assumption n Spot Price(CAD/USD) : 1.578 Forward Price(CAD/USD) : 1.578 Tax Rate: 33.40% Scenario: +/- 3.1%

Currency Exposure Canada (III)

Original Policy

( in millions)
future spot price movement Commercial Exposure Gain/loss on hedged position 17 (16) -3.10% +3.1%

50% Hedge Ratio

Balance Sheet Exposure Gain/loss on translation

Impact on Net Income EPS* Impact as % of EPS

(43)
(18) (0.03) -0.40%

41
17 0.03 0.38%

Currency Exposure Canada (IV)

Proposed Policy

( in millions)
future spot price movement Commercial Exposure Gain/loss on hedged position 26 (24) -3.10% +3.1%

75% Hedge Ratio

Balance Sheet Exposure Gain/loss on translation

Impact on Net Income EPS* Impact as % of EPS

(43)
(12) (0.02) -0.27%

41
11 0.02 0.26%

Currency Exposure Canada (V)

Comparison

Currency Exposure Canada

Higher hedge ratio -> Less volatile But more hedging costs more! Depend on GMs overall risk tolerance. Regardless of what hedge ratio GM chooses, we strongly suggest the firm to deviate from its original 50% policy in respect to its Canadian division. Essentially follows GMs hedging policy: when exposures become large or volatile enough, they should be specially treated.

Forwards or Options?

options :higher payoff when the CAD depreciates, higher loss when the CAD apreciates. Intuitively, considering the volatility and the premium cost, forward contracts are more desirable.

Forwards or Options? (II)

While options lend more volatility to hedging, GM uses a delta hedging strategy (with rolling forwards). Since GM has a 12-month rolling forward strategy, the manager needs to balance its positions according to changing exposure amounts and expectations. Thus, option contracts, in this case, are a more flexible choice that cost GM only the premiums, but can be easily traded in the market. Forward contracts, on the other hand, are a fixed obligation locked in with a large notional amount. Therefore, options end up being a better hedging instrument for GM.

General Motors and Argentina

The Argentinean Peso was experiencing high volatility in the forwards market and faced a serious risk of devaluation, due to the risk of debt default, and rising inflation. As the probability of default grew, so did the probability of devaluation. For the purpose of our calculation of GMs implied risk in Argentina, we have assumed that the probability of default equals the volatility of the Peso. Thus, volatility is very high at 40% in the short term and 50% in the long term.

General Motors and Argentina (II) GM has one assembly plant in Argentina, and a total of $300 million in net operational exposure, and also faces a substantial amount of translational risk due to devaluation of the Peso in the future. To calculate the average volatility for GM, (as transactional exposure is affected by volatility in the medium and short terms, while translational exposure is mainly affected in the medium term), we take the average volatility of 45% in our calculations.

What GM Should Have Done As forward prices were rising (rise in volatility), GM should have seen this as an indication of possible devaluation in the future, and should have converted its excess cash and current revenues into stable currencies (example USD) a while ago. While it has managed to do so to a certain extent already, we argue that this should have been standard practice due to the inherent uncertainty of a 1:1 peg system.

What GM Should Do Now GM can adopt a strategy of paying its employees and suppliers as per the real exchange rate between the Peso and the Dollar, calculated by comparing the PPPs of both countries. It should also demand its receivables from the Argentinean government instantly, in order to convert them into USD before devaluation. If this is not possible, it can enter into a forward contract with the government at a predetermined exchange rate, in order to partially offset its exposure.

What GM Should Do Now (II) We have calculated the implied risk of the net exposure to be as follows Net Exposure x 40% x Average Volatility of Peso = 300*0.5*0.45 = $67.5 million. Thus, GM should choose to hedge against these risks as long as the costs do not exceed 67.5 million. Ongoing translational exposure will affect the book value of both, assets and liabilities over a period of time. Thus, they are largely affected by medium-term volatility and should be hedged using one-year forward contracts.

Conclusion Hedging Its good! But only when its responsible. Hedging isnt an all access pass to risk-taking! Canada GM has a huge transactional exposure in Canada. Thus, it needs a diversion in its hedging policy. Argentina GM should have done more to prepare itself for Argentinas Peso devaluation. BUT, its not too late now. It can hedge + aim to change its receivables to USD while keeping its liabilities in Pesos. It can also fix rates according to the PPP to ensure fair value.

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