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Foreign Exchange Hedging Strategies at General Motors Case Study Solution

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Page 1: GM Hedging

Foreign Exchange Hedging Strategies at General Motors

Case Study Solution

Page 2: GM Hedging

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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 GM’s 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?

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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 needsTo manage earningsTo speculateTo make evaluating a company’s operations easierTo 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? 50% ration; “passive”

How to hedge? Forwards (0-6) and options (6-12)

Where to hedge? 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. CADTransactional and translational exposures

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

3. YenOperating exposure

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GM’s 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?

GM’s 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”“implied risk” is calculated simply to determine if GM should hedge.

We hedge the “underlying”“underlying” risk.

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How much to hedge?

The value of our car is $30,000 and there is a 5% probability of accidentThe expected outcome of accident is losing $1,500How 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: GM’s 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”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 GM’s 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 ExposureGM is short about CAD 1.7 billion

It has to pay Canadian suppliers for materials and services.

A transactional exposure.

According to GM’s 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 Canada’s balance sheet includes significant pension obligations.A total balance sheet exposure is CAD 2.1 billionGM’s 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 50.0% 75.0%SCENARIO - CAD is: 3.1% Stronger 3.1% Weaker 3.1% Stronger 3.1% Weaker

Commercial exposure12-month rolling net receivables forecast (CAD) (1,682) (1,682) (1,682) (1,682)

Notional hedge amount at hedge ratio (CAD) (841) (841) (1,261) (1,261)Net cash (CAD) - - - - FX hedge put in place (CAD) 841 841 1,261 1,261

Net FX exposure (CAD) (841) (841) (420) (420)

GM Worldwide US GAPP FX exposureGM Worldwide US GAPP FX exposure (CAD) (2,143) (2,143) (2,143) (2,143)

Earnings impact on GM WorldwideGM Worldwide FX gain/(loss) (43.4) 40.8 (43.4) 40.8FX gain/(loss) on hedges 17.0 (16.0) 25.6 (24.0)GM Worldwide pre-tax income impact (26.4) 24.8 (17.9) 16.8GM Worldwide after-tax (35%) income impact (17.2) 16.1 (11.6) 10.9

ScenarioCAD/USD FX rate 1.5780 1.5780 1.5780 1.5780Range (3.1%) 3.1% (3.1%) 3.1%CAD/USD FX rate - sensitivity 1.5291 1.6269 1.5291 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)

(1,500,000)

(1,000,000)

(500,000)

-

500,000

1,000,000

1,500,000

2,000,000

1.4000 1.4500 1.5000 1.5500 1.6000 1.6500 1.7000 1.7500 1.8000

Exp + Fwd

Exp + Opt

Exposure

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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

2. Change sourcing • Get same benefits as Japanese automakers – buy plants

in Japan

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 GM’s 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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24Source: Rohan Williamson, 2001, “Exchange rate exposure and competition: evidence from the automative industry,” Journal of Financial Economics 59, 453-475

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25Source: Rohan Williamson, 2001, “Exchange rate exposure and competition: evidence from the automative industry,” Journal of Financial Economics 59, 453-475

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26Source: 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