1. Should multinational firms hedge foreign exchange rate risk? If not, what are the consequences? If so, how should they decide which exposures to hedge? Generally, multinational firms should hedge foreign exchange rate risk. Because foreign exchange risk 1) Affects existing income statement items and balance sheet assets, liabilities, and equity through translation exposure. 2) Influences the value of outstanding foreign-currencydenominated contracts and obligations, thus firm’s earning and cash flow through transaction exposure. 3) Impacts firm’s future revenues and costs, thus firm’s earning, cash flow, enterprise value, and equity value through operating exposure. In order to reduce cash flow uncertainty and earning volatility, to minimize negative impacts from foreign currency gain & loss on firm’s value and equity, in most cases foreign exchange risk should be hedged and exposures should be managed. If translation exposure is not hedged, under FASB 52 the value of financial statement items that translated at current exchange rate may negatively affect consolidated earnings and equity value in case of adverse exchange rate movements. If firms fail to hedge transaction exposure, firms will face uncertainty in future cash flows and earnings since foreign exchange swings tend to fluctuate cash flows and distort earnings. If operating exposure is not managed, unfavorable exchange rate changes may jeopardize or threaten firm’s competitiveness and prospects thus affect profit margin, sale volume, and enterprise value. Firms base on following factors to decide which exposures to hedge: 1. Significance of impacts. Firms may first determine how large will exposures affect earnings, cash flows, and firm value by analyzing exposure value, currency volatility, value at risk, scenario analysis, sensitivity analysis, and etc. Only those exposures have potentials to exert significant negative impacts should be hedged. 2. Cost of hedge. Explicit costs such as option premiums and implicit costs such management dedication and human resources occupation associate with hedging specific exposure. Only hedge those exposures with hedging benefits exceeds their costs. 3. Firm-based risk management policy. Multinational firms may already establish matured risk management policy that predetermines and prescribes the guild for which exposure to hedge. Besides, firms may prioritize which exposure to hedge first when conflicts arise from hedging different exposures.
3. Should GM deviate from its policy in hedging its CAD exposure? Why or why not? From exhibit 9 and exhibit 10, we observe that GM faced a transaction exposure CAD 1.682 billion and a translation exposure CAD 2.143 billion. According to GM’s passive hedging policy, GM should hedge 50% of CAD 1.682 billion commercial exposure and ignore translation exposure that stems from CAD 2.143 billion net monetary liabilities. But FX & Commodities Manager proposed to increase hedge ratio to 75% for the commercial exposure. The scenario analysis provided in Table 1 examines the impact of 75% hedging versus 50% hedging on the GM’s income statement and earning per share under plus-or-minus 3.1% movement of current exchange rate 1.5780. Since commercial exposure is the present value of estimated future 12 months cash flows, it has no instant effect on current financial statements. Only the hedge position created and translation exposure affect current earning. According to the analysis presented in table 1, we find that hedge 75% of commercial exposure will largely reduced net income volatility and EPS volatility (32.03% reduction). Therefore we recommend GM to deviate from its current policy and approve 75% hedge for the CAD 1.682 billion exposure. We also observe that by increasing the hedge position for transaction exposure, GM actually is “hedging” the translation exposure effectively. Because the impact (on earning) from the long CAD hedge position partially cancels out the impact (on earning) from the short CAD translation exposure. If the GM considers it’s desirable to minimize translation exposure in order to reduce its effect on year-end financial result and neglect hedging cost, 100% hedge position for commercial exposure will further smooth earning and reduce earning volatility by 64.59%, based on the analysis in Table 2.
Table 1 From the consolidated income statement, we estimated the tax rate. Year 2000 1999 1998 EBIT 7164 9047 4944 Income tax 2393 3118 1636 Tax rate 33.40% 34.46% 33.09% Tax rate average 33.65% CAD/US +3.1% - 3.1% hedge ratio 50% D USD USD commercial exposure C$ 1.5780 1.6269 1.5291 (million) -1,682 hedge position (million) C$ 841 $532.95 $516.93 $550.00 net monetary liabilities C$ $1,358.0 $1,317.2 -$1,401.49 (million) -2,143 5 1 Gain/Loss on hedge position (million) -$16.02 $17.05 Gain/Loss on translation exposure $40.83 -$43.45 (million) Effect on earning before tax (million) $24.81 -$26.40 Effect on net income $16.46 -$17.51 (million) Effect on EPS (dollar per share) $29.93 -$31.84 CAD/US +3.1% - 3.1% hedge ratio 75% D USD USD commercial exposure C$ 1.5780 1.6269 1.5291 (million) -1,682 C$ hedge position (million) $799.43 $775.39 $825.00 1,262 net monetary liabilities C$ $1,358.0 $1,317.2 -$1,401.49 (million) -2,143 5 1 Gain/Loss on hedge position (million) -$24.04 $25.58 Gain/Loss on translation exposure $40.83 -$43.45 (million) Effect on earning before tax (million) $16.80 -$17.87 Effect on net income $11.14 -$11.86 (million) Effect on EPS (dollar per share) $20.26 -$21.56 50% 75% reduction effect hedge hedge volatility(range) of NI 33.97 23.00 32.30% volatility(range) of EPS 61.77 41.82 32.30%