General Motors – Currency Risk Exposure

Li YiLiao Shin-WeiPeng YangTanvi 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. GM’s 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 GM’s

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

Cash flows Amt ( million)

Inflows 11,613

Outflows 13.294

Total (1,682)

B/SAssets

Amt ( million)Liability

2,597 4739

(2,143)

Why Is CAD an issue?

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)

( in millions)

future spot price movement

-3.10% +3.1%

Commercial Exposure

Gain/loss on hedged position

17 (16)

Balance Sheet Exposure

Gain/loss on translation (43) 41

Impact on Net Income (18) 17

EPS* (0.03) 0.03

Impact as % of EPS -0.40% 0.38%

Original Policy –

50% Hedge Ratio

Currency Exposure – Canada (IV)

( in millions)

future spot price movement

-3.10% +3.1%

Commercial Exposure

Gain/loss on hedged position

26 (24)

Balance Sheet Exposure

Gain/loss on translation (43) 41

Impact on Net Income (12) 11

EPS* (0.02) 0.02

Impact as % of EPS -0.27% 0.26%

Proposed Policy –

75% Hedge Ratio

Currency Exposure – Canada (V)

Comparison

Currency Exposure – Canada•Higher hedge ratio -> Less volatile•But more hedging costs more!

•Depend on GM’s 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 GM’s 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 GM’s 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 – It’s good! But only when it’s

responsible. Hedging isn’t 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 Argentina’s Peso devaluation.

•BUT, it’s 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.

Questions?

•Ask us a question – get a jelly bean!