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Foreign Exchange Hedging Strategies at General Motors- Transactional and Translational Exposures Case Solution

Solution Id Length Case Author Case Publisher
706 1840 Words (5 Pages) Mihir A. Desai, Mark F. Veblen Harvard Business School : 205095
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The main considerations revolve around expected devaluation of Argentinean Peso. Some of the reasons that would impact their profitability due to their exposure in ARS include;

ARS being pegged with USD,

requiring tight monitoring of foreign exchange operations in the country, by the government.

Zero deficit law

passed by the Senate in 2001. This would result in extensive borrowings and non repayment of existing debt.

Downgraded credit rating;

reflecting increased probability of default.

Political problems

such as lack of trade liberalization, state reforms, pension and health care reforms.

Operational problems, translational losses in particular;

this would result in lower asset values and much higher liability values, when converted to USD. Much of the borrowings in is USD, by Argentinean subsidiary. Devaluation would simply increase the value of these loans, adversely impacting debt to equity ratio of the parent company. Since, most of the assets of the subsidiary are in Argentinean Peso, when translated back to the USD, assets would be valued at lower values, which would subsequently result in low value of equity.

Following questions are answered in this case study solution:

  1. Should Multinational firms hedge their foreign exchange rate risk? If not, what are the consequences? If so, how should they decide which exposures to hedge?

  2. What do you think of GM’s foreign exchange hedging polices? Would you advise any changes?

  3. Should GM deviate from its policy in hedging its CAD exposure? Why or why not? Is such a deviation consistent with policy?

  4. Should GM deviate and change its hedging decision on the CAD If it does, what instruments should it use to accomplish that hedging?

  5. If GM does deviate from its formal policy for its CAD exposure, how should GM think about whether to use forwards or options for the deviation from de policy?

  6. Why is GM worried about the ARS exposure? What operational decisions could it have made or now make to manage this exposure?

  7. Should GM increase its hedge with respect to the ARS? How costly would it be and would it be worth it?

Foreign Exchange Hedging Strategies at General Motors Transactional and Translational Exposures Case Analysis

Operational decisions to manage the exposure

Exports from Argentinean subsidiary, which will increase sales of the subsidiary since other currencies would be appreciating mitigating the risk of ARS getting depreciated.

Hedge the US borrowing through either forwards or options. If, unsure about the future direction of currency then use options. However, in this case, ARS is expected to depreciate. So, use forwards to short Argentinean Peso in future. Moreover, GM could use options for the whole amount, rather than for only 50%.

Should GM increase its hedge with respect to the ARS? How costly would it be and would it be worth it?

GM treasury division is concerned with the associated costs of hedging the ARS exposure, with both forwards and options.

Without considering any costs, it has been already mentioned that within the current scenario, GM motors would report ARS 300 million losses in the income statement. The situation demands an analysis of the associated costs of hedging and the expected payoff. Premium for options is at 4.56% approximately on a month contract, whereas the cost of a forward contract, one month, would amount to USD 6.4 million.

ARS is expected to depreciate, once the peg is going to be removed. Current rate of the peso against the dollar is 1: 1 whereas after depreciation, it is going to be 2: 1. If, a put option on ARS is purchased, with an expiry of 1 month, premium of 4.56%, notional amount to ARS 300 million, strike rate of 2: 1 (ARS: USD). Upon expiry of the contract, if the foreign exchange rate is any where below the strike rate, this will result in a positive payoff. Following table illustrates expected pay offs on a put option, with 1 month expiry and a notional principal of ARS 300 million based on assumed foreign exchange rate scenarios:

ARS to USD

1

1.5

1.75

1.8

1.9

Strike price

1.5

1.5

1.5

1.5

1.5

pay off in ARS

0

0

75

90

120

*Premium @ 4.56%

1.14

1.14

1.14

1.14

1.14

Net off premium

-1.14

-1.14

73.86

88.86

118.86

*Premium calculated pertains to one month, i.e. 4.56% divided by 12

Same analysis could be conducted over forward contracts. If, a 1 month forward contract is purchased with a rate of ARS 1.5 per USD and upon expiry, the rate is ARS 2 per USD, then the net pay off would be positive at any time whenever spot rate is lower than the forward rate.
Following table illustrates pay off over 1 month forward contract.

ARS to USD

1

1.5

1.75

1.8

1.9

Locked in rate

1.5

1.5

1.5

1.5

1.5

Pay off

-150

0

75

90

120

Cost

6.4

6.4

6.4

6.4

6.4

Net off cost

-156.4

-6.4

68.6

83.6

113.6

If GM does deviate from its formal policy for its CAD exposure, how should GM think about whether to use forwards or options for the deviation from de policy?

Finance literature dictates us that it is always costly to implement a hedging strategy using derivates, as compared to futures. The reasons for options being expensive is due to the fact that there is a required premium to enter into an option contract, whereas there is no premium required for entering into futures / forward contract. This will always result in reduction in payoff from option contract.

Required analysis will require calculation of the expected payoffs after considering the costs of both the hedging instruments. With forwards the associated costs normally would include, trading costs, commissions etc. Without any calculations, we can always state with surety, that if forecasts are correct, then use forward contracts. However, if there is uncertainty then use options. For example, in case of a put option, there is a downside protection, whereas if prices increase, then we can always let the option expire and take no action, with a resultant loss equal to the premium only. In case of a forward, the rates move contrary to our expectations, then losses would magnify.

Should GM deviate from its policy in hedging its CAD exposure? Why or why not? Is such a deviation consistent with policy?

GM must deviate from its policy in hedging its CAD exposure. As per the stated policy, only 50% of the exposure will be hedged. GM’s exposure to CAD amounts to CAD 1.7 billion so as per the policy, amount to be hedged would equal CAD 0.85 billion. On the other hand, only transactional exposures will be hedged. These factors would lead to a net monetary liability exposure and in case of depreciation of Canadian Dollar; significant reduction in equity is possible. However, such a deviation would be consistent with their policy. GM would only be hedging their transactional exposure, which will eventually result in the hedging of their transactional exposure.

Should GM deviate and change its hedging decision on the CAD If it does, what instruments should it use to accomplish that hedging?

The two instruments being considered are forwards and options. On the trade date, forwards contracts have a zero cost, as no premium is involved, whereas with options premium cost has to be considered. The strategy being discussed in the case involves comparing a 50% hedge using forward contracts and a 50% hedge using options and plotting the payoffs on the same graph, with payoff on the y-axis and spot prices on the x-axis. The point of intersection represents the spot price at which the payoff from both the instruments would be the same.

Following chart illustrates the discussed scenario.

Spot Price (CAD: USD)

1.2

1.3

1.5

1.8

2

2.2

Total Pay off – Options (CAD)

-0.15

-0.15

-0.15

0.85

4.85

8.85

Total Pay off – Forwards (CAD)

-8.02

-6.02

-2.02

3.98

7.98

11.98

At spot price of slightly below 1.6, the two instruments will yield the same pay off. At spot prices, above 1.6, forwards must be preferred.

What do you think of GM’s foreign exchange hedging polices? Would you advise any changes?

GM has implemented a passive policy for foreign currency management, in order to minimize the management time and costs. In addition, the policy contained guidelines regarding commercial exposures, financial exposures, translation exposures (which were not included under the hedging policy), accounting treatments and reporting of hedging activities.

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