Foreign Exchange Hedging Strategies at General Motors - Assignment Example

Foreign Exchange Hedging Strategies at General Motors Introduction A general motor was established in 1908 as motor vehicle dealer. Later, the company expanded its operations to over 30 countries and had sales terminals in more than 200 countries (Desai, 2004). It was a market leader for motor vehicles since 1931 covering more than 15% of the global market as of the year 2001. In 2000, the company had total sales of $184.6 with earnings of $4.4 billion. Following the expansion strategies of major parts of the world, the General Motors exposed the company to currency exchange risks that resulted in gains and losses reported in the company’s income statement (Desai, 2004, p. 3). The GM market share values include 20% in Latin America, 10% in Europe market and a target of 4% of the Asian Market. Apart from motor vehicles GM offered other products and services including satellite television and commercial satellite, automotive, business financing, and mortgage services, and locomotive as well as health duty transmissions (Desai, 2004.p. 5). The company traded on the New York Stock Exchange Market as well as Dow Jones Industrial average. The variations of the income statement compelled the company’s management to utilize strategies to manage the income and cash flow volatility faced by the GM. Its sales outside the U.S. accounted for over 25% of the company’s sales revenue as a result of global business activities (Desai, 2004). General Motor’s Foreign Exchange Exposure Initially, the GM management held responsibility for managing the financial transactions (Clark, 2002). The main worry was how to manage the exchange exposures posed by the Argentinian Peso following the proposed currency devaluation, exposure to Canadian dollar and the strategic issue concerning fluctuating Japanese yen. In order to manage the company’s financial risks a GM focused on building the capacity of its manpower through training and giving the experienced personnel senior managerial positions (Desai, 2004, p. 5). However, as GM extended its operations across the globe, they increased exposures to foreign currencies. A company involved in sales and purchases using foreign currency face the challenges of commercial exposure (Madura, 2012). For example, GM had an estimated $900 million in Yen exposure based on predicted payables and receivables. GM encounters the following financial exposures in the international operations. Translation risk refers to changes in valuation of foreign assets and liabilities on a transnational organization’s consolidated balance sheet due to the influences of exchange rates. It is the sensitivity of recognized domestic currency values of the firm’s contraction cash flow denominated in foreign currencies to unexpected exchange rate changes” (Desai, 2004, p. 6). It arises due to desire for reporting and consolidation, to transform the results of international operations from local to home currency. This nature of risk is determined by the net value of foreign assets and foreign liabilities (Clark, 2002). In other words, transaction exposure arises from a contract where the contract value is fixed for a long time in an atmosphere where the exchange rate is changing indiscriminately. Transaction risk is the effect of exchange rate values of committed cash flows due to changes in the exchange rate values. The future cash flows arise from receivables from export or payables from import deals as well as dividends repatriations. The contract duration may be short or long, transaction risk results from a single transaction of account payable or receivable (Madura, 2012). Economic or competitive risk denotes the effects of exchange rate variation on the present value of indefinite future cash flows. It encompasses the influence of future income and expenditures due to variations of exchange rate as a result of changes in volume and prices (Desai, 2004, p. 8). It refers to the magnitude in which the firms’ value could be influenced by unexpected exchange rate variations. Economic exposure if beyond the control of individual firm and will affects the entire firm’s assets. When a currency depreciates in relation to another foreign currency the local organizations in the domestic country whose currency has depreciated stands to benefit relative to the foreign companies using the same currency (Clark, 2002, p. 125). In this case the domestic company can pass the benefits to its consumers and downplay the foreign companies. By 2001, there were more than 24 automobile companies operating in USA that led to decline in sales revenue and volume of the GM (Desai, 2004, p. 4). Also, on a global scale GM experienced stiff competition from other automotive companies such as the Japanese Toyota. Due to global competition the market share of GM, Chrysler, BMW and Ford declined from 72.4% in 1994 to 63% in 2001. On the other hand, the Japanese market strengthened from 22.84% to 26.29% while the German automobile companies gained market strength from 2.15% to 5.62% during the same period (Desai, 2004, p. 4). Question 2: General Motor’s Foreign Exchange Hedging Strategies The GM’s Treasurer’s Office was responsible for implementing financial risk management strategies. The GM treasurer’s office was composed of Domestic Financial group dealing with foreign exchange hedging for GM entities in Latin America, Middle East, North America and Africa. Another group of GM treasurer’s office was the European Regional Treasury Centre (ERTC) dealing with foreign exchange operations in Asia Pacific and European foreign exchange exposures (Madura, 2012). The establishment of a treasury office in regions where the business units were already established was essential for controlling the business. The foreign exchange risk management policy was enforced in General Motors with a purpose to achieve specific objectives. These includes minimizing cash flow and income instabilities, reduce time spent of global financial exchange management, and finally, matching the financial exchange strategies with the organizations management strategies (Madura, 2012). Foreign Exchange Exposure faced by General Motors Foreign currency exposure refers to the degree in which the company is affected by the variations of exchange rate. Transaction and translation risks faced the GM Company due to variations in exchange rates (Madura, 2012). For example, by having operations in Canada the GM has to convert USD into CAD thus creating risks of loss or gain due to fluctuations in currency exchange rate. Managing the risk due to Canadian dollar exchange rate GM used forward and options contracts. The disadvantages of a forward contract are that it is a fixed contract that ties up the company and prohibits them from taking advantage of other favourable movements of the exchange. In Argentina, GM had to engage strategies to for managing risks due to devaluation of the local currency. The GM financial exchange hedging strategy involved forward and options contracts (Desai, 2004). Forward hedging strategy They used “forward contract to combine outright exposure plus 50% hedge and a combination of outright exposure plus 50% hedge using options” (Desai, 2004, p. 10). This was a speculative hedging approach whereby the GM treasury aimed at accepting the most profitable option in case the outcome differed from the expected results following the intersection of the axis of the two options. Forward contracts were a zero cost contract while options involved purchase premium. The outright exposure was used to determine the GM’s gains or loss in foreign exchange realized from the contract outlay. Forward contract hedging would partially offset future cash flow with sum of gain or loss of outright and cash settlement of the forward contract aggregating to the net values of a forward tactic (Desai, 2004). Options hedging strategy Under the options contract, the outright exposure was determined by contract purchase with the value of outright exposure and options payoff being equivalent to a net value of the options strategy. For example, by taking a contract price with a forward price equivalent to 1.5667 and 1.45% premium the option returned earnings less the premium where the option was in monetary form (Desai, 2004, p. 16). However, where the contract expired out of money the gain or loss on a contract price increased or reduced by the contract value. Hedging the Peso exposure involved elimination of peso cash balances and their conversion into US dollar to the European Regional Treasury Canter. The other hedging option for Peso exposure was purchasing of materials for the industry locally to reduce the transaction and competitive exposure (Madura, 2012). Economic/competitive exposure Hedging strategy The U.S. market was highly competitive with main competitors like Ford, GM, PACCAR and Chrysler. These main competitors occupied the market share of about 63% and had well established business operations outside the U.S. GM anticipated a significant currency risk due to its huge involvement in the international market (Desai, 2004). For example, in 2000 the company anticipated a liability of $13 billion due to foreign currency exposure. In order for GM to hedge against losses related to foreign currency they employed a variety of hedging approaches such as swaps, forward contracts, options and so on. GM hedges predicted and engaged the firms into one-year commitment for transactions involving foreign currencies (Desai, 2004). However, the got commitments of up to six years for commodities used in the automobile industry such as aluminium and other non-ferrous metals. The company suffered a transaction loss of $100 million in 2000 and translation loss of $162 million in 1999 (Desai, 2004). Question 3: Do you agree with General Motors foreign exchange hedging strategies? I disagree with the General Motor’s hedging strategies as far as the shareholders’ interests are concerned. The transaction hedging strategy used by GM is merely speculative and increases risk to the company (Desai, 2004, p. 23). For example, the company will increase tax burden due to hedge forward since the value is taxable were the loss on forward hedge does not reduce the value of tax value. Also, the success of this strategy depends on the ability of the management to speculate the outcome of market activities thus it increases the risk of translations (Desai, 2004). GM did not hedge the Translational risk even though it carried significant risk. Concerning Argentina Peso, the GM hedged 50% against the likelihood of currency devaluation and local government subsidies (Desai, 2004). However, the Hedging should have been increased to 75% from the 50% used by the company portrayed high volatility. GM should have considered borrowing local currencies in order to reduce the transactional risks (Desai, 2004). Question 4: Passive policy The GM policy aimed at hedging 50% of commercial exposures and defined derivative mechanisms for hedging the financial exposures. The system did not take into consideration the translation exposures for hedging. However, financial exposures such as loan repayment schedules, cash flows and equity injections were hedged as per individual cases (Desai, 2004). Hedging for commercial exposures followed planned investments such as assets or equipment so long as they met the two essential criteria by applying 100% hedge ratio to the expected repayment period. The criteria include 10% implied risk equivalent to the unit net worth, and amount exceeding $1 million (Desai, 2004). Exposure to the accounting treatment focused on reducing income instability although the company would use the existing financial standards (FA 133) that would give GM an option to be “marked-to-market and gains and losses flowed through the income statement” (Desai, 2004, p. 17). Finally, the treasury group conducted a thorough review of GM’s reporting procedure that was carefully tracked and well controlled as part of hedging process. The use of hedging technique is not good option for the shareholders because it does not provide the investors with an opportunity to gain from strengthening foreign currency (Desai, 2004). Investors are risk takers and invest their resources where there is a probability for increasing revenue. Furthermore, investors have full information about the market and can hedge the risk themselves by selecting appropriate portfolio that can reduce the associated risks as asserted by Modigliani-Miller theory. As suggested by Purchasing Power Parity (PPP) theory exchange risk does not exist because it is offset by the changes in price levels of two countries (Madura, 2012). In the short-run, the PPP will always vary hence does not require hedging. Furthermore, Capital Asset Pricing Model (CAPM) suggests that the systematic risk is significance and require hedging rather than exchange rate risks. Hedging is focused on preventing loss without any chance of increasing revenue in case the foreign currency (Madura, 2012). Conclusion General motors were the leading automobile industry with operations in all parts of the globe. However, with international operations, the company exposed themselves to foreign exchange risks. The company experiences translational, transactional and economic risks due to expansion of its operations. General motors use forward contracts and options to hedge out their risks. However, the use of passive hedging policy does not match stakeholders’ value because any hedging option limits the chances for creating wealth. Therefore, companies should avoid any form of hedging strategy since hedging reduces value creation for the shareholders resources. Bibliography Clark, E. (2002). International Finance, (2nd ed.). London: International Thomson Learning, Spring. Pp. 1-665. Desai, M. A. (2004). Foreign Exchange Hedging Strategies at General Motors. Harvard Business School. Pp. 1-28. Madura, J. (2012). International Financial Management, (12th ed.) South Western College Publishing Company. Pp. 1-752. Read More