Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures

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For both hedge ratios the combination of the outright exposure plus a hedge using forward contracts, with the combination of the outright exposure plus a hedge using options were compared. Two graphs below with future spot prices (x-axis from 1,4 to 1,8) against cash flow payoff (y-axis ranging from 13,5 to 11 million CAD) demonstrate two produced lines intersect.

[pic 1]

[pic 2]

That point of intersection (1,6 CAD per USD) represented a sort of break-even point—if GM Treasury’s expected future spot exchange rate was different from that point, GM could choose the strategy that was more profitable (less costly).

The next step implied comparison of the income statement impact of a 75% versus a 50% hedge ratio for plus-or-minus 3,1% move around the 1,5780 exchange rate. A favorable scenario (gain due to FX movements) and an unfavorable scenario (loss due to FX movements) were based on the after-tax gain/loss impact from the projected CAD cash flow as well as from the CAD net monetary liability. By dividing this amount by the 550 million shares GM had outstanding, the extent to which proposed deviation would reduce EPS volatility was determined:

Hedge ratio

50%

75%

Scenario: CAD is

3,1% stronger

3,1% weaker

3,1% stronger

3,1% weaker

After-tax income impact

-17,16

16,13

-11,62

10,92

EPS volatility

-0,03

0,03

-0,02

0,02

The level of loss and gain both are higher in 50% hedge ratio as compared to the 75% hedge ratio, similarly the EPS volatility is also higher in 50% as compared to 75%. The difference in volatility is due to higher level of uncertainty involved in unhedged amount.

Translational risk which usually is not hedged by the firms can, however, have significant impact on the earnings of a company, thus hedging it is a safer option. Transaction risks should be hedged if there is high level of volatility in foreign exchange rates as it is in the case of Canadian subsidiary. Alternative strategies can also be used by netting off the amount or using futures.

Argentina:

The case of the Argentinean subsidiary is different to the Canadian one. The Argentinean government is facing significant financial problems which throw doubts on overall country’s financial stability and indicate default (and therefore devaluation) is at the corner. Thus some calculations are needed to see how a potential devaluation of the Argentinian peso against the US dollar from 1:1 to 2:1 forecasted by treasury analysts would impact GM subsidiary.

General GM’s position in Argentina is characterized by net ARS exposed assets of 129,1 million USD and net USD exposed liabilities of 302,7 million USD. ARS devaluation from 1:1 to 2:1 can have two impacts:

- Local currency equivalent of USD borrowing will grow;

- Translation loss on GM Argentina ARS denominated net assets.

The financial market review for forwards and options on the ARS and compilation of historical prices on one-, six-, and twelve-month forward rates of the peso vs. the dollar made it possible to assess hedging a $300 million exposure based on shorter term contracts or year-long contracts:

After 1 month

After 6 months

After 12 months

Forward rate

1,05

1,35

1,50

Cost of hedging

6,40

28,70

40,30

No hedge

Cost of hedging

0,00

-215,90

Total gain/loss

50% hedge

Total gain/loss

-122,84

-184,59

-208,93

75% hedge

Total gain/loss

-76,31

-168,93

-205,45

As the table demonstrates, it’s more costly for the company not to hedge the exposure at all. At the same time, long-term contracts are a few times more expensive than short-term ones. Comparing 50% and 75% rates, losses are bigger when 50% hedging instruments are use. The longer the period of the contract, the smaller this difference gets though: for a 1-year contract total losses for a 50% and a 70% ratios are almost the same.

Additional measures and strategies that can be taken into consideration to hedge the risks include:

- Balance sheet hedge in the form of either increasing exposed ARS assets without simultaneously increasing ARS liabilities, or reducing ARS liabilities without simultaneously reducing ARS assets.

- The intracompany system of leads-and-lags could be introduced.

- Replacing US$-denominated loans to local currency ARS loans (e.g., converting the US-denominated loans to be payable in ARS using current spot rate of 1:1)

- The use of long term forex swap could be another alternative. It is quite feasible for companies who have their investments stuck up in a particular country and can’t withdraw the investment from there for prolonged periods of time.

Conclusions:

Since

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