Hedging at General Motors
Being one of the largest automakers in the world, General Motors (GM) undertakes its manufacturing operations in over 30 countries with vehicles being sold in over 200 countries. Through undertaking its international operations it also subjects itself to various types of foreign exchange exposures due to fluctuations in the values of currencies; to manage this problem it has adopted a passive hedging policy and aims to reduce the impact of foreign exchange exposures on the business.
The first part of this report outlines the various types of foreign exchange exposures that GM can subject itself to and also outlines what methods can be used to reduce the risk associated with changes in the value of currencies; the policies adopted by GM are then outlined and the strategic decisions required in ensuring the viability of the policies. An assessment of GM’s hedging policy is then made and various points are outlines in regards to potential improvements that can be made ranging from how options are exercised to whether translation exposures should be included in the hedging policy.
One of the key exposures facing GM is the Canadian Dollar Exposure. This exposure was incurred as a result of changes in accounting standards; that required GM Canada to assign the US dollar as its functional currency due to the large number of assets denominated in the currency. GM’s policy specifies that it should only hedge 50% of its commercial operating exposures and translation exposures should not be hedged. Whereby the CAD exposure is CAD 1682 Million, it would have a significant impact on the firm, more so due to the CAD 2143 million translation exposure, thus a solution is posed as to whether the policy should be adapted to 75% hedging in order to reduce risk.
The possible devaluation of the Argentinean Peso from ARS 1:$ to ARS 2:$, also has a significant impact on GM due to its operations in Argentina. The exposure which is purely translation in respect to the parent company is not hedged according to the policies; and would incur a loss of $64.6 million if the devaluation was to take place. To ensure this risk is reduced, it would be viable for GM to hedge this exposure either through the use of forwards or by using non-financial instruments such as changing the functional currency.
1. Foreign Exchange Exposure and Risk Management
1.1 Types of Foreign Exchange Exposure
There are three predominant types of financial exchange exposure which multinational entities face as a result of foreign exchange rate movements, these are: Transaction Exposure, Operating Exposure and Translation Exposure. •Transaction Exposure – measures the change in outstanding financial obligations made prior to change in exchange rates but due to be settled after changes in exchange rates take effect. Deals with cash flows as a result of contractual obligations (Eiteman, Stonehill and Moffett, 2010).
•Operating Exposure – measures the change in the present value of the firm resulting from changes in the expected future operating cash flows of a firm caused through changes in exchange rates. Deals with the competitive aspect of the firm through changes in exchange rates (Eiteman, Stonehill and Moffett, 2010). •Translation Exposure – measures the risk associated with changes in owners-equity (assets, liabilities etc), because of the need to translate foreign subsidiary statements into a single currency reporting statement (that of the parent company) for worldwide consolidation of financial statements (Eiteman, Stonehill and Moffett, 2010).
1.2 Hedging Foreign Exchange Exposures
Through hedging MNE’s aim to manage the risk associated with the various types of foreign exchange exposures. Hedging is the acquiring of a position that will rise or fall in value and offset a fall or rise in the value of another position; positions can include the acquiring of assets, cash flows or contracts (Eiteman, Stonehill and Moffett, 2010).There are two ways to hedge the risk associated with foreign exchange exposure: use of financial instruments and natural hedging.
Using Financial Instruments to Hedge
Hedging through the use of financial instruments is whereby instruments such as forwards, options and money markets are used to manage the risk of foreign exchange exposure. •Forward Hedges are where a contractual obligation exists regarding the buying or selling of a currency at a specified fixed future rate on a specified future date. It requires a source of funds (Eiteman, Stonehill and Moffett, 2010). •Option Hedges are a right not an obligation to buy or sell a specified currency at a specific rate on a specified future date. It allows for speculation on the upside while still limiting the loss (Eiteman, Stonehill and Moffett, 2010). •Money Market Hedges is another method, this contract is a loan agreement whereby a firm borrows in one currency and exchanges the proceeds in another currency (Eiteman, Stonehill and Moffett, 2010).
This type of hedging is whereby foreign exchange exposures in outflows of cash are offset by inflows of cash through matching of transactions (i.e. Revenues and Expenses). Natural hedging focuses on operating cash flows; for example a receivable is offset by a payable in the same currency without the use of financial instruments, this however requires consideration of synchronising values of the cash flow and timing of the cash flows (Eiteman, Stonehill and Moffett, 2010).
Strategic Decision making by MNE’s
There are various factors that need to be taken into consideration by MNE’s when implementing a strategy to hedge the various types of foreign exchange exposures including the cash flows of the MNE, its attitude to risk, the ability to forecast future changes in rates and to some extent the differences in attitude between management and stakeholders.
1.3 GM’s Risk Management Policy
General Motors has three primary objectives to be achieved through the use of hedging to manage the risk associated with foreign exchange exposure: •Reduction of cash flow and earnings volatility – this objective is associated with a conscious decision to hedge only transaction exposures (cash flows) and ignore translation exposures (balance sheet). •Minimize costs and time dedicated to foreign exchange management – this objective was initiated as a result of inefficient employment of resources allocated to foreign exchange management as there was a lack of out performance in the passive benchmarks. •Aligning foreign exchange management in a consistent manner with the operation of GM’s automotive business – the final objective was associated with the view that foreign exchange exposures should be managed on a regional basis as regional management would be more consistent due to greater local understanding.
Because of these objectives the active policy was changed to a passive policy to ensure these objectives were achievable.
Designing the Hedging Policy
GM’s hedging policy is designed by the risk management committee, which meet quarterly to review and set the treasury policy for General Motors and its subsidiaries. They evaluate parameters and benchmarks for managing risk and determine the criteria regarding various aspects of operating policies and procedures. The policy is designed in a way that it has not only broad principles but also detailed execution procedures. The Hedging activities are concentrated in two centres which allow for pooling exposures across groups while still maintaining high local market knowledge in the two different time zones to ensure that General Motors is active in each of the major foreign exchange markets. The two centres are: •Domestic Finance Group in New York – Hedges for General Motor entities in North America, Latin America, Africa and Middle East. •European Regional Treasury Centre – Hedges for European and Asia Pacific foreign exchange exposures.
1.4 GM’s Hedging Policy
GM hedges foreign exchange exposure by grouping them into two main aspects: Commercial Operating Exposures and Financial Exposures.
Commercial Operating Exposures were hedged using specific policy guidelines. The idea was to hedge 50% of all “significant” commercial exposures on a regional level and was based around accounts receivables and payables for the coming 12 months. Each region was paired by currencies and allowed for flexibility when considering net exposures. A riskiness model was applied on a regional basis to confirm whether foreign exchange exposures were “significant” enough to warrant hedging.
Implied Risk = Regional Net Exposure X Annual Volatility of Currency Pair
The significant aspect relates to the riskiness model, whereby any exposure exceeding $10 Million would be hedged, and for particularly volatile currency the implied risk threshold would be reduced to $5 Million. Normally exposures were hedged for 12 months but in the case of the volatile currency the exposures were hedged for 6 months only. The use of instruments to hedge was as follows: •Forwards were used for months 1 to 6 and Options were used to hedge for months 7 to 12. •The hedging was executed on a rolling forward basis, meaning options were replaced by forwards once they were inside the specified time horizon. •Some of the options were re-sold when outside the boundary of specified time horizon.
The economic performance of hedges was monitored and re-adjusted on a delta basis. This took into account how effectively a risk was covered with the probability of exercising the instrument. The expected delta was 37.5% (100% of forwards and 50% of options, covering 50% of exposure).
Financial Exposures such as loan repayment schedules and equity injections were hedged on a case by case basis but hedged 100% using forward contracts. Dividend payments were only hedged once declared and in same manner as commercial operating exposures. Commercial Capital expenditure exposures were only hedged if they met one of the two criteria: amount exceeding $1 Million or implied risk equal to a minimum of 10% of unit’s net worth. These were hedged 100% using forward contracts. Translation Exposures were omitted from the hedging policy but were considered if they were large enough to warrant the attention of senior finance executives. Assessing GM’s Hedging Policy
The policy objectives tend to be met through the criteria outlined by General Motor’s hedging policy. Through using two hedging centres, the policy allows for local market knowledge while still being active in two of the largest foreign exchange markets in different time zones. This allows for efficient hedging as currencies are pooled based on region thus reducing the possibility of inaccurate forecasting. The overall policy allows for a reduction in costs and time management, however the use of options could be executed more efficiently to reduce costs; i.e. selling “all” unused options when considering rolling forward basis. Through executing the instruments in this way, it shows that changes in future exchange rates are not estimated and are more likely to be accurate and through the appropriate mix of forwards and options it allows for flexibility. All other aspects are met on a criteria basis; however the lack of measures in translation exposures can potentially increase the risk of owners to losses in equity in an aggregated manner. The policy outlines every detail of possible exposures and thus can be beneficial when assessing the company; overall, the policy is viable in respect to meeting the objectives but can be subject to change on the basis of its performance and conditions of the market.
2. Canadian Dollar Exposure
2.1 Types of Canadian Dollar Exposure
Since GM uses US Dollar as its functional currency, it is exposed to two types of exposures, namely transaction exposure arising out of its inflows and outflows in the income statement being in Canadian Dollars (CAD) and Translation exposure arising due to majority of its Canadian subsidiary’s assets and liabilities being in CAD. The translation exposure in GM’s case is CAD 1682 million. As per the GM’s formal hedging policy it is only allowed to hedge 50% of this amount. The balance sheet (translation exposure) amounting to CAD 2143 million was not supposed to be hedged as per GM’s formal hedging policies.
2.2 Translation Exposures and Its Effect
As per the accounting standards, the currency which dominates the flow of transactions in a subsidiary is termed as the functional currency. Since most of the transactions in the Canadian subsidiary of GM were in US dollars, it became the functional currency of GM Canada. The fluctuation in CAD will impact the income statement and will also be reflected in the share holder’s equity in the balance sheet.
As depicted in figures 1.1, 1.2 & 1.3 the fluctuation in the CAD and its impact on the on the consolidated income statement and balance sheet of GM. Depreciation of the CAD will result in lower shareholder’s equity thereby resulting in negative Earnings per share (EPS).
2.3 Hedging the Canadian Dollar Exposure
GM’s passive hedging policy did not allow for hedging the translation exposure stemming from the CAD 2.1 billion net monetary liability left a large CAD exposure that could affect the GM’s financial results. Therefore these issues resulted in increasing the hedge ratio from 50% to 75% by the GM’s management.
Spot Rate: CAD 1.5621/USD Forward Rate: CAD 1.5667/USD Exchange Rate after Appreciation: CAD 1.5137/USD Exchange Rate after Depreciation: CAD 1.6105/USD
As depicted in figure 1.6, if the CAD appreciates, the hedge ration of 75% will enable GM to earn additional 17.14 million. If CAD depreciates GM should stick to its formal hedging strategy of 50% to minimize losses.
3. Argentinean Peso Exposure
3.1 Devaluation of the Argentinean Peso
In order to show the impact of peso devaluation, it is necessary to first adopt a perspective on the case. The two prospects are to analyze it from GM parent company’s perspective, and from GM Argentina’s perspective, but for the purposes of this case, which is to provide a perspective on GM’s hedging policy, its rationale and implications for the business, we will adopt the parent company’s perspective. Following this, the devaluation of the Argentinean peso will have a direct impact on the value of GM Argentina’s monetary assets and liabilities as seen in figure 1.7. Translating the balance sheet of GM Argentina in pesos after devaluation would result in GM seeing its assets and liabilities reduce in value. Even though ARS denominated cash has been eliminated from the subsidiary’s balance sheet, some receivables and payables still exist.
From GM’s perspective, the USD denominated assets and liabilities are not subject to impact from devaluation, therefore an analysis of the impact should include only the ARS entries on the balance sheet of GM Argentina. Figure 1.7 shows how a devaluation of the peso from ARS1/$ to ARS2/$ would affect GM’s consolidated balance sheet.
As could be seen from the Figure 1.7, the high amount of ARS denominated assets in GM’s balance sheet in comparison to the liabilities creates a significant amount of exposure. When the amount of devaluation is added, the exact amount of translation loss can be seen by multiplying the net exposed assets by the percentage of devaluation. The amount calculated is quite significant, due to 2 reasons: one is the predominance of assets over liabilities, and the other one is the major devaluation of the peso. Taking into account high probability of the devaluation to occur, such a high amount of exposure will have a negative impact on GM’s yearly results, therefore it is important to hedge it. Even though the exposure in question is translation exposure, which is not subject to hedging under GM’s policy, the Argentinean case is somehow special, because it creates a “significant” exposure, and so requires rethinking of GM’s hedging policies and consideration of possible hedging scenarios.
2.2 General Motors hedging approach to the Argentinean Peso
According to GM’s policy, exposure is generally to be hedged at 50% through forwards for the first 6 months and options for months 7-12. Using forwards to hedge the peso exposure has certain implications, considering the high probability of occurrence of peso devaluation. If GM Argentina enters into a forward contract, it would agree to sell the pesos received from the settlement of its payables in return for dollars at an agreed exchange rate. The cost of doing this is the difference between the exchange rate today and the rate as specified by the contract. However, the forward rate has already taken into consideration the possibility of devaluation and according to Exhibit 11 of GM case, the 12 month rates in August were as high as ARS 1.50 per USD.
The calculations, provided in the case, imply an extremely high cost of forward contracts – even if GM decides to use the cheapest option and opt for a 12-month contract, it will cost the company around $40mil. Even though they were made on the basis of hedging a $300 mil exposure, it is still reasonable to conclude that the cost of hedging the actual $129 mil would be considerable. There are other factors that should affect the decision of whether or not to use forward contracts. One is the possibility of the devaluation occurring, which, even though is estimated to be high, is still not 100% certain. The other one is the uncertainty of the size of devaluation.
When taken into consideration, these factors make the cost of hedging seem restrictively high. This leads to the conclusion that it is worthwhile to consider alternative measures for hedging the exposure. Except finding out what the impact of the devaluation will be, in order to propose appropriate hedging strategies, it is also necessary to discover what results hedging actions should produce. Since the exposure is translation exposure, a possible goal of the hedging strategy could be to reduce the assets and increase the liabilities (balance sheet hedge). We will take a look at options, their benefits and costs, as well as their feasibility in order to make a conclusion about the most efficient way for GM to hedge its positions.
Increasing ARS denominated liabilities
A translation exposure could be hedged by borrowing in the currency exposed, thus increasing debt in the company’s books. In GM’s case, it could arrange for a peso loan, which it would have to repay later, probably in the conditions of a devalued peso. The amount of the loan should be equal to the amount of the net exposed assets in pesos or 129.1 million. In order for the company to avoid increase in peso denominated assets as well, it could choose from two options. One is to immediately exchange the received pesos for USD, thus increasing the USD denominated assets in its balance sheet. The other one is that it transfers the ARS to GM parent company, which can in their turn exchange them for USD. If taking out a loan is to be avoided, then GM Argentina could delay repayment of its existing loan, thus indirectly increasing liabilities. In both cases the cost of hedging will be equal to the money that GM Argentina will have to pay additionally to repay the loan.
Reduce the amount of ARS denominated assets
The main fact to consider here is the nature of GM Argentina’s assets. They are mainly receivables, and are owed by the government. Normally, GM could try to negotiate an earlier payment (leading) of the amounts due in return for a discount, but in this case it is very likely that such negotiations would not be successful. Therefore, a more viable option for GM Argentina would be to try and sell its receivables for a discount. The value of the discount would represent the cost of this hedging technique, so due to the lack of information in the case a comparative analysis between the different alternatives could not be made.
Looking at GM Argentina’s balance sheet in Figures 1.7 and 1.8, it could be noted that it has a much higher amount of USD denominated liabilities than ARS denominated ones. In the likelihood of devaluation it is reasonable for the company to reduce its USD debt and to try to transfer it in pesos. It could use a loan taken out in pesos and immediately converted in USD to repay its USD liabilities, thus not only reducing USD liabilities, but also increasing peso ones.
GM Argentina could consider changing its functional currency to the USD. In this way it will eliminate all its translation exposure and turn it into transaction exposure. However, it will also mean that the devaluation of the peso will have to be reflected in GM’s consolidated income statement. It could also try to match its cash flows with those of another subsidiary of GM, which also has some peso exposure, for example, importing components from Argentina, whose payables are due at the time the peso receivables are due. The components could be invoiced to the name of GM Argentina, and the account could be settled with the peso denominated receivables of GM Argentina.
GM’s hedging policies are viable by nature; however some changes such as the sale of options and hedging translation exposures need to be undertaken to ensure further risk management and cost reduction. Regarding the CAD exposure, it is recommended that GM assesses it forecast of the changes in value of CAD, if the CAD is expected to depreciate then the current policies should be maintained, however if appreciation is forecasted, it is recommended that GM revises its hedging policy to cover 75% of the exposure. The Argentinean peso devaluation on the other hand, requires that GM hedge its translation exposure either using natural hedging or using instruments as a decrease in shareholders equity is likely through the devaluation. This however depends on whether the Argentinean peso devalues or not and the length of time for which the devaluation is to be maintained.