ESSEC MS TF - FAM
FINM 32203 – International Finance
‘‘Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures’’
Executive Summary: The purpose of this case study is to analyze the different strategies to hedge against foreign exchange risks; those risks are subdivided into transaction, economic and translation exposures. Throughout this case study, we are going to present the different exposures that General Motors faces and how GM should or should not deviate from its hedging policies regarding the special cases of the CAD and the ARS exposures. All along the case, we also present our suggestions to improve GM’s ...view middle of the document...
- The last category of foreign exchange exposure is the economic exposure or ‘competitive exposure’. It assesses the effects of long run changes in exchange rates on the competitiveness of companies from different locations.
A hedge is an action taken by a company to cover itself against risk. A company like General Motors, which faces transaction and translation risks, can hedge its exposures by internal and external techniques. Internal techniques involve the company in switching its own operations (location, sources of supplies) to reduce the impact of foreign exchange exposures. External techniques involve the use of financial instruments such as options, derivatives and other services provided by banks.
To understand whether a company should hedge or not, we can consider three different hedging policies:
1. Hedge nothing
Small companies unlikely have the awareness of hedging techniques and they do not probably have the capacity to absorb any significant exchange rate losses. This is the most risky position. Furthermore, no hedging policy increases volatility and uncertainty of future cash flows.
On the other hand, academic economic studies indicate that in long term a ‘no hedge’ policy should produce the same results as a fully hedged policy, (Zero Sum Theory). Some people argue there is no point of hedging, as shareholders already diversified and hedged their portfolio (Modigliani & Miller).
To cover currency depreciation ‘price maker’ companies may simply raise the price of its goods in foreign currencies
2. Hedge everything
Hedge everything policy is common in heavy engineering companies when transaction are large and ‘one off’ and where profit margins are tight. A variation on the ‘hedge everything’ policy is to use forward contracts to cover exposures where adverse exchange rate exposures are expected, and to use options when favorable movements seem likely. In practice many companies use forward contracts for certain cash flows in foreign currency and use options to cover uncertain cash flows. Corporate hedging reduces the volatility of earnings and the volatility of future cash flows. Furthermore, lower risk of financial distress may increase debt capacity for a hedged company, and suppliers and customers will prefer to deal with less risky firms. The other consequence of hedging everything is to decrease the cost of capital and to increase the value of the firm as the cost of capital is the basis of the discount rate applied to future cash flows when valuing the business.
3. Selective hedging
Selective hedging involves taking a view on the future movements of exchange rates, the object being to hedge only those exposures where the anticipated risk of loss exceeds the opportunity for gain. Companies first set up their degree of risk aversion. This policy requires time and professional expertise. To contradict Modigliani & Miller theory, individual investors are unlikely to be able to diversify exchange risk...