Foreign Exchange Hedging Strategies at G

Manchester Business School Worldwide 60477 Global Finance - July 2014-15 2nd Semester

Course Assessment 3

Foreign Exchange Hedging Strategies at General Motors

Prepared by: Ahmed Abdelazim Abdelmeguid Mohamed Student Number: 9594599 Program & Cohort: MBA Part Time – July 14 Cohort Assignment Reference: GF/9594599/Jul15/3 Assignment Word Count: 2,180

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Table of Contents Introduction..........................................................................................................................................3 Explaining the Types of Foreign Exchange Exposure at GM ...................................................3 Explaining FX Hedging Strategies Used by GM ............................................................................7 Reviewing GM's FX hedging Strategies ..........................................................................................8 Is Hedging Strategies Compitable with Shareholder Value Creation? ..................................9 Conclusion .......................................................................................................................................... 11 References .......................................................................................................................................... 11

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Assignment Reference: GF/9594599/Jul15/3

 Introduction General Motors is one of the world’s largest automaker with 15% global market share and manufacturing operations in more than 30 countries in 2001 (Case study). Due to the global expansion, GM’s monetary transactions in different currencies are increased and hence they are more exposed to volatility in currency exchange rates. As currency exchange rate fluctuates, the financial position of GM and its competitive position are influenced. In this essay, we will go through the types of FX exposure that GM faces, how GM had managed foreign exchange risk, and how effective GM hedging strategies are. We will also discuss the views against and for passive hedging strategy and its suitability with the creation of the shareholders’ value.

 Explaining the Types of Foreign Exchange Exposure at General Motors In this section we will identify and discuss the types of FX exposure that GM faces. A) Translation (Balance Sheet) Exposure: Translation exposure is the type that MNCs face when they consolidate the subsidiaries’ financial statements reporting in different currencies from the MNCs’ home currency. Since GM-worldwide produces its financial statements by consolidating all subsidiaries’ financial statements. The financial statements of each subsidiary are usually measured in the local currency of where it operates.

As foreign exchange rates fluctuate from time to time, the translation of subsidiaries’ financial statements affects the consolidated financial statements of GM (Madura and Fox, 2011)1

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Jeff Madura and Roland Fox, International Financial Management, 2nd Edition, 2011, pp. 357

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The blow graph illustrates the geographic breakdown of GM’s net assets that are exposed to translation exposure. We will discuss the translation exposure at the regional level.

Figure 1: Source: Case Study

 North America: It is the main region of GM’s worldwide production process. Since the U.S dollar is the functional and operating currency of GM- Canada, it is not subject to translation exposure (although it is subject to transaction exposure and will be discussed below).  Europe: GM- Europe’s net assets represent 19% of GM’s worldwide net assets. Hence, GM Europe is subject to translation exposure that would impact its financial position, however the implied risk is related to the degree of volatility of Euro against U.S dollar.  Latin America: The situation in Argentina, particularly, is more critical as experts anticipated devaluation of ARS against USD from 1:1 to 2:1 (case study). This would lead to a huge translation loss and reduces GM’s worldwide equity balance and its value when the assets hold by GM Argentina are consolidated to GM’s worldwide financial statements. Imagine that net assets of GM- Argentina is 500 million peso, in case the peso devaluated by 50% due to some reasons, this put GM worldwide under huge financial pressure. Page 4 of 11

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GM-Argentina Value in (Mln ARS) Assets, net Translation Gain (Loss)

500 0

GM Consolidated (Mln USD) ARS/USD ARS/USD = =1 2 500 250 0 (250)

 Others: GM had equity investment in many Japanese companies like Fuji, Isuzu, and Suzuki. As a result of these investment, GM investments in Japan is exposed to translation exposure. If a company has Yen-dominated net assets, this would impact GM’s financials due to the fluctuation of exchange rate. GM’s investment would depreciate by the depreciation of Yen against dollar.

B) Transaction Exposure: Transaction exposure is known as the degree to which the value of the future cash transaction is affected by the fluctuation of exchange rates (Madura and Fox, 2011)2. Generally, we can argue that each GM’s subsidiary is subject to transaction exposure at different level. GM- Canada is subject for transaction exposure although USD is the functional and operating currency. However, CAD-dominated suppliers and CAD- dominated pension payments are higher than CAD-dominated sales. GM- Canada is highly exposed to Canadian dollar as it is considered as the core supplier of GM-North America (case study). Imagine that GM-Canada bought material from Canadian supplier for CAD 1 million due in 90 days. On the day of purchasing, the rate is CAD1/1USD, but the rate became CAD0.9/1USD when the payment is due GM-Canada will pay the Canadian supplier the due amount but now the value became $1.1 MN and this will hurt the financial position if not hedged. 2

Jeff Madura and Roland Fox, International Financial Management, 2nd Edition, 2011, pp. 340

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GM-Argentina is subject to transaction exposure as well. And the situation there is more critical as it was expected that the peso would be devaluated by 50% due to country economic risk. Due to the expected devaluation of ARS, GM-Argentina would be required pay AR 600 million to settle the $300 USD loan (equivalent to ARS 300 million peso pre-devaluation). This transaction will have a significant impact on the subsidiary’s financials. GM had transaction exposure to the Japanese yen as it issued Yen-dominated bonds, and had Yen-dominated loan. In case that yen appreciated against dollar, GM will need more dollars to pay its yen liabilities.

C) Competitive Exposure: Fluctuation of foreign exchange rate doesn’t only affect GM’s financial position but also affects its competitive position against its competitors. GM is more concerned about how the fluctuation of Yen affects it market share. As U.S market represents 50% Japanese automakers’ revenue (case study), they are competing GM in its home. GM team figured out that Japanese cars’ cost structure has high portion of Japanese parts (20%-40). According to that estimation, the devaluation of Japanese yen by 10% against dollar would lead to a cost reduction of Japanese cars by 2% to 4% for US consumers and the Japanese automakers will have a cost advantage against US domestic producers as the sales is elastic by 2 so any increase in the price of GM cars relative to Japanese cars by 2% would reduce its sales by 4% and hence GM is subject to lose its market share.

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 Explaining FX Hedging Strategies Used by GM In this section we will discuss how GM’s managed the FX exchange exposures. GM’s hedging strategies was developed to (1) Reduce volatility in cash flows and earnings. In order to meet this objective, GM hedged the transaction exposures only and ignored to hedge the translation exposure. However, GM classified its transaction exposure into commercial exposure and financial exposure. Hedging commercial exposure aimed to address the cash flow risk associated with the day to day operations such as receiving cash from sales and paying to suppliers. GM used to forecast the receivables and payables over forecasted period (12 months) to assess the notional exposure. For example if GM- Europe’s receivables less payable are £100 million, this would be considered as a notional exposure. However the volatility of Pound against the Euro would determine the implied risk that needs to be considered for hedging. For all implied risks of $10 million or greater, the regional exposure was required to be hedged. However capital expenditures exposure, like purchasing fixed assets, was hedged separately from other commercial exposure as they hedge any CaPeX exposure greater than $1 million or equivalent to 10% of the unit’s net worth. For Financial exposure resulting from loan repayment or equity transactions, it was hedged on case by case basis. (2) Minimize the management time and costs dedicated to global FX management. GM had figured out that investing time and money in active FX management hadn’t resulted in outperforming passive benchmarks, as a result they followed passive approach rather than the active one. Passive strategy developed to hedge only 50% of the commercial (operating) exposure and the declared dividends payments by using forward contracts for the

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first 6 months and options for the second 6 months. However, commercial (CapEx) and other financial exposures were 100% hedged. (3) Align FX management in a manner consistent with how GM operates its automotive businesses. In order to achieve this objective, GM used to hedge its commercial exposure on a regional level. Each region had to assess its implied risk and each region’s exposure was hedged and managed separately.  Reviewing GM's FX hedging Strategies Based on the above explanation, We can argue that GM shouldn’t have ignored translation exposure as GM- Europe’s net assets represent 19% of GM’s worldwide net assets (Case study), so any depreciation in the Euro value by 10% against U.S. dollar negatively affects GM’s comprehensive income and financial position (retained earnings) and GM’s worldwide would experience losses from currency translation equivalent to 1.9% of its worldwide net property due to translation process of consolidating GM-Europe financial statements. The same concept is applicable on GM-Latin America as ARS is anticipated to devaluate against U.S dollar which will lead to a huge translation losses by reducing its share price. According to the analysis, GM is highly exposed to translation exposure and hedging this risk should be considering by using forward contracts or future contracts on the expected subsidiary’s earnings by selling the exposed foreign currency one year forward (Madura and Fox, 2011)3. Also, we can argue that GM should have developed its hedging strategy to hedge commercial foreign exposure on global level not on regional level. GM would save hedging costs if they managed to offset exposures in different region. For example if with respect to GBP GM-Europe had a net receivable of $10 million and GM- Latin America had a net

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Jeff Madura and Roland Fox, International Financial Management, 2nd Edition, 2011, pp. 431

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payable of $10 million, so the exposure could be offset as the GM- Europe would receive the cash from the receivables and use it to pay the exposed payable amount of GM- Latin America when it became due. If GM considered hedging strategy on global level and offsetting exposures, they would use active approach and hedge 100% of the FX commercial exposures rather than a passive one. However, GM’s strategy to invest in Japanese companies helped the company to diversify exposure and issuing 500 million Yen-bonds offsets cash flow volatility. GM would have to hedge its competitive exposure increasing production capacity and presence in low costs to take advantage of lower value currencies via export (eg. Argentina) as its high cost owing to location concentrated in U.S which has an impact on operating cash flow for material, and labour. Despite operations in Argentina leave GM sensitive to the economic and political situation in Argentina, the potential devaluation in ARS would bring a commercial advantage to GM.

 Is Hedging Strategies Compitable with Shareholder Value Creation? GM basically changed its hedging policy and passive approach replaced active one due to minimize the resources deployed for managing FX risks and for cost effectiveness purposes as well. Although FX hedging strategies are developed by MNCs to cover the fluctuation in foreign exchange rates that impacts the financial position, there are some argument that FX exposure shouldn’t be hedged as it will not create shareholders’ value. The argue against hedging FX was built on the PPP theory as it states that changes in price levels in two countries will offset the exchange rate. Theoretically, when a country’s inflation rate increases relatively, the demand on its currency will decrease, however in reality there are transportation, logistics, and tariff costs that would support the argument for hedging FX. Dufey and Sirinvasulu4, argued that there are deviations from PPP as even if it holds the price 4

MBSWW, Global MBA, Global finance, Study Guide 2, chapter 10. Page 9 of 11

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levels in two countries, it doesn’t hold any commodity and companies will be affected by FX rates. According to Capital Assets Pricing Model (CAPM), the most important issue is the undiversifiable market risk, however the authors argued that fluctuation in exchange rates really matter and it will impact the volatility of cash flows and companies’ earnings. Another argument against FX hedging claims that investors (shareholders) could do hedging by themselves if they are interested and if they think hedging would create value, so MNCs don’t need to hedge their FX exposure. However, this argument is not realistic because investors will face size barriers to access hedging markets as they will be required to hedge huge amounts. In addition to that, investors will face lack of information related to the operation of the business and the associated foreign exchange exposures. Another argument associates with market efficiency, as it means that the gains and losses resulting from volatility in FX average out over a period so hedging FX will incur costs for hedging things that is irrelevant or offset over the time (Study guide) 5. However, volatility in cash flows is the concerns not only managers, but regulators and shareholders as well. Another argument states that future spot exchange rate is difficult to predict, hence hedging is like gambling, however hedging is a planning tool to focus on the future not to guarantee results. A final argument against managing FX risks says that the gains and losses resulting from fluctuations in foreign exchange rate may be used as a hedging tool for consumptions bundles of the company’s investors. Dufey and Sirinvasulu6 argue that consumption bundles are relates to the investors personally and it should be hedged by the investor directly however any foreign exchange exposure associated with the business should be the responsibility of the management to take the proper action for hedging.

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MBSWW, Global MBA, Global finance, Study Guide 2, chapter 10 MBSWW, Global MBA, Global finance, Study Guide 2, chapter 10. Page 10 of 11

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 Conclusion Managing FX exposures in GM is not that easy mission as GM has significant exposure to ultimately each single currency. The management should consider operation in low value currencies to have cost advantage and this will imply more translation exposure that the company should think about.

 Refrences:  Case study Foreign Exchange Hedging Strategies at General Motors, The Case Center, Harvard Business School, 2005  Madura and Fox, International Financial Management, 2nd Edition, 2011, pp. 357  Madura and Fox, International Financial Management, 2nd Edition, 2011, pp. 340  Madura and Fox, International Financial Management, 2nd Edition, 2011, pp. 431  MBSWW, Global MBA, Global finance, Study Guide 2, chapter 10.

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