General Motors Transactional Translational Exposures

GENERAL MOTORS – TRANSACTIONAL & TRANSLATIONAL EXPOSURES Prepared For Prof. Vishwanath S. R. School of Management & Entrepreneurship Shiv Nadar University

Group -2 Manohar Monish Rajan Raghavendra

Q-1) Should multinational firms hedge foreign exchange risk? If not, what are the consequences? If so, how should they decide which exposure to hedge? Multinational firms should hedge their foreign exchange risk. MNC operate in multiple countries and there will be huge risks associated with the Transactional, Translational and operating exposures. The following are the consequences for not hedging the risks    

High volatility in the cash flows, which results in the huge fluctuations in the profits of the firm Firm may face issue in paying off its debt or bond payments. Currency fluctuation may leads to high debt for the firm, which may lead to its bankruptcy. Eg: Currency fluctuations resulted high debt for Suzlon group in India. Company can lose its market share to the local players, as the import cost of its raw materials can increase due to the fluctuations of the foreign exchange. Value of the Receivables and payables of a company can get affected due to the foreign exchange fluctuations.

Hedge the exposures: Any firm has following exposures associated with foreign exchange risk.

Transaction Exposure: This exposure occur when the firm buys or sells its goods on credit or borrowed/ lends in foreign currency. Hedging the Transaction exposure: The best possible solutions for hedging this risk are by using Forward-market hedge, money market hedge and currency options. 

In forward-market hedge, the firm can buy a forward contract to hedge its risk associated with the currency fluctuation.

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In Money market hedge, the company can borrow in one currency in which it is going to receive its payment during the due date and convert it to the local currency and invest it. When the loan comes due, it will pay it back with the money it receives from its operations.

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In Options market hedge, the firm can buy an options and hedge its risk. The option provides asymmetric risk protection, where the loss can be the premium paid for the option and there will be a huge potential for profit, if the currency is volatile and exceeds the exercise price.

Translation Exposure: This exposure occur, when the firm has foreign subsidiaries and their financial statements are converted in to home currency for the reporting purpose. The best possible solutions for hedging this risks are by using Balance-sheet hedge, forwardexchange hedge, money market hedge and swaps. 

In Balance sheet hedge, firm can offset the risk by maintaining equal amount of assets and liabilities in each currency that offset each other.

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In forward-exchange hedge, the firm can hedge the risk by buying or selling a forward contract in the exposed currency and execute the contract in the spot market at the future date.

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In Money market hedge, the company can borrow in the foreign currency and convert it to the dollars and invest it. When the loan comes due, it will pay it back by converting the dollar investment into foreign currency at the future spot rate.

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In Swaps, the firm can exchange an amount with another firm with an agreement to return funds after a certain period of time.

Q-2) What do you think of GM’s Foreign Exchange Hedging Policies? Would you advise any changes? GM has implemented following policies for hedging its foreign exchange fluctuations. The primary objectives of GM foreign exchange risk policies are   

Reduce the cash flow and earnings volatility (to hedge the cash flow exposure and ignore the Balance sheet exposure) Minimize the management time and costs dedicated to global FX management. Align FX management with GM automotive business.

GM measured the riskiness of the FX exposure using below formula to decide on the need of Hedging. If the implied risk exposure is more than 10 million, then it has to be hedged. For highly volatile currencies, it is below $ 5 million. This provides a guidelines for the team to hedge the risks. Implied Risk = Regional national Exposure * Annual Volatility of currency pair GM uses Forwards and Options to hedge their risk. It is required that options to make 25% of hedge position, which provides a flexibility and limited down side risk. GM currently not focusing on policies to hedge the Translation exposure. It has to work on creating policies for hedging the Translation risks, which have a major impact on the balance sheet.

Advices:   

The firm has non centralized treasury function, where the tasks are performed non-centrally. They should implement a centralized function and use USD for the profitable results not the local currencies. Currently the company has the hedge ratio of 50% for the commercial transactions which has more uncertainty. They could have maintained the hedge ratio of around 75%, which provides more certainty. The firm should work on minimizing its Translational risks by having equal liabilities with the assets in the local currencies so that they get net off.

Q-3) Should GM deviate from its policy in hedging its CAD exposure? Why or Why not? General Motors with its Canadian subsidiary does its business operations primarily in US Dollars as currency. Therefore, accounting standards also required in USD despite their large Canadian dollar assets & liabilities. Hence, CAD dominated cash flow exposures are experienced as foreign currency exposure in income statement due to loss/gain. Also, a net cash flow exposure has resulted due to large payments due to Canadian suppliers. Risk of a high obligation exists to deliver benefits on future pension and postretirement benefits in Canada. To determine whether to deviate or not, sensitivity analysis of hedging ratio on income statement to be performed for both 50% & 75%. Assume, plus or minus 3.1% volatility in exchange rate movement. CAD Currency FX rate = 1.5780/USD 12- month CAD Cash flow forecast(exhibit 9) = CAD $1682 Hence, 50% = 0.5*(1682)= CAD (841)

Sensitivity analysis on Gain/Loss Shift in FX rates

Loss at 50% Hedge

Loss at 75% Hedge

Ratio

Ratio

Towards Positive Side Towards Negative Side

1368.238 1285.95

2052.35 1928.93

Differential

(766)

(123.42)

Gain/Loss Since more loss in assets at 50% hedge than 75% hedge ration, it is implied that company should deviate from its CAD exposure to minimize the losses. Hence, deviation is necessary & would be profitable.

Q-4) If GM does deviate, how should GM think about whether to use forwards or options for the deviation from the policy? To find out the deviation, let us calculate the Forward contract hedged at 50% and also the options contract hedge at 50%. Next, calculate the difference between the forward contract and options contracts.

From the analysis, it is evident that Option contracts protects much better in CAD exposure than forward contract.

Q-5) Why is GM worried about the ARS exposure? What operational decisions could it have made or now make to manage this exposure? 

GM is worried about ARS exposure because the Argentina government is at serious risk of

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defaulting on its debt, with $16.5 billion of foreign loans due in 2002. Credit analysts have already downgraded Argentina to well below the investment grade, the GM treasury believes that the short term probability of default had touched 40%, and medium term

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rose to 50% since the government had taken any substantial action. In this case, if there is a default then a large devaluation is surely on the cards, with GM Argentina’s balance sheet showing USD Monetary liabilities at 325.7, a devaluation of ARS will increase the liabilities substantially.

How can GM manage this ARS exposure? 

One of the ways to counter this ARS exposure would be to translate the US denominated loans with the local currency ARS, but this cannot be feasible at the moment since the Argentinian

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banks will not be able to lend in such large money. Another way could be for GM Argentina to export to other GM subsidiaries which uses USD, thereby increasing the receivables in USD that can offset the payables and loans in USD.