Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures
Danial Wahaj Khan
This report is based on a practical scenario solution of General motors. The report addresses the problem given in scenario which is the change in policy of hedging with detailed reasoning. The report then looks at the different available hedging instruments to the firm. Profitability of both instruments has been compared and lowest cost option was selected to mitigate the transactional risk. Translation risk has also been seen at different hedging ratio levels; current one and the proposed one. The options were more profitable to the firm that has been recommended. Argentinean subsidiary’s long term local currency problems have then be discussed with few different strategies that managers can adopt there. The appendix contains the technical calculations and graph that were necessary to support the decisions. INTRODUCTION:
The case study addressed the exposure of General Motors to the foreign risk that arises due to its presence at a number of geographical locations and transactions in different foreign currencies. Corporate hedging policy does exist in this regard however there are two special cases that were addressed in the case study. The matters require special consideration as the existing policy is not very much appropriate to these two matters. One matter is the company’s exposure to the foreign exchange risk arises from Canadian subsidiary which has functional currency USD so CAD is foreign currency for this subsidiary. There are two types of risks that GM faces in this situation; one is translation risk and the other one is transaction risk. The company’ is looking at different hedging strategies to mitigate the risks and dealing with the matter exceptionally from the company’s policy. In order to that different instruments (options and forward contracts) should be analyzed for different level of hedge ratio plus favorable and unfavorable scenarios. Translation risks should also be discussed and impact of them on income statement should be estimated. The second matter is the management major translation risk arising in Argentina subsidiary due to recent major devaluation in the local currency. A strategy needs to be evaluated to deal with this long term risk. CANADIAN DOLLAR HEDGING:
Forward rates contract is a popular and highly used hedging instruments. It has its advantages and disadvantages both. The main disadvantage is that it is a binding contract so company can’t take advantage of favorable movements. It is usually used where company is not interested in gains rather pure hedging. Options are option to buy or sell particular currency and they are usually expensive than other instruments as they give advantage of realizing upside exposure. Different hedging strategies for Canadian dollar risk are used. Particularly forward rates contract and options are used. The objective of our calculation is to reduce the total amount paid by GM in respect of 1.7 billion CAD cash to the suppliers. We first find out which is the most profitable hedging instrument on 50% hedge ratio then we estimate the total cost paid in using 75% and 50 % hedge ratio. Using the example data given in the case study we can estimate the total cost that should be paid by the company using 50% hedge ratio. The graph shows that the options are more profitable at 1.6 exchange rate.1.6 is the rate where both lines intersect each other. (App-1) Now we can analyze the income statement gain/ (loss) for the 2 scenarios for both 50% hedge ratio and 75% hedge ratio. The level of loss and gain both are more in 50% hedge ratio as compared to the 75% hedge ratio and similarly the EPS volatility is also more in 75% as compared to 50%. The difference is volatility is due to higher level of uncertainty involved in non hedged amount. (App-2) Translational risk is usually not hedged by the firms...
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