Q5

Why is GM worried about the ARS exposure? What operational decisions could it have made
or make to manage this exposure?

The Argentinian Government aimed to control the historical inflation tendencies through
maintaining a Peg to U.S dollar at USD 1: ARS 1 with a $16.5 billion of foreign loans
coming due 2002. There is a high probability that Argentina will default on its debt which
made credit analyst downgrade Argentina to 7 points below the investment grade. Since
Argentina in 2001 still had not addressed key issues such as trade liberalization, state reform,
pension and health care reform, Consequently, GM treasury Latin America experts had
assessed the probability of default to be 50%. A default would very likely be accompanied
by large devaluation in the Argentinian currency.

GM is worried about the devaluation of the Argentinian currency especially that it has an
amount of 190 million ARS monetary assets and a total of $325.7 million USD monetary
liability. What makes the situation more complex is that the devaluation would have an
ongoing impact on the subsidiary and If it took place, GM Latin America would witness a
huge loss in fulfilling its liabilities and face a decrease in its total asset value. Since the
market is expecting a potential devaluation, there is a huge demand on hedging the
Argentinian currency against the U.S Dollar and Consequently, the cost of that hedge raised
substantially. Feldstein found that the forward contract rates has been rapidly raised over the
recent month to be $6.4 million for one month forward and reach $40.3 Million for the 12-
month forward contract.

There are some operational decisions to manage and mitigate the cost of exposure which are
called natural business hedge. They take place through reducing peso-denominated assets and
substitute peso-denominated liabilities for hard currency-denominated ones.
Eliminating the peso cash balances and transferring them in USD to the European regional
treasury center would decrease the Peso-denominated assets. Moreover, adopting some
strategies to bring in revenues in more stable foreign currencies through exportation would
defend the company strongly against the devaluation. Finally hedging the Peso against the
U.S dollar through forwards and options in a 100% hedge ratio would help in mitigate the
cost of devaluation.

The following tables illustrates the Net payoff of hedging $300 Million exposure based on
rolling over shorter term contracts or purchasing year-long contracts, when the potential
devaluation of Peso against the dollar ranges from 1:1 to 2:1

Hedging Using Forward contracts for 1 month

If a 1 month forward contract is purchased with a rate of ARS 1.5 per USD and upon expiry,
the rate is ARS 2 per USD, then the net pay off would be positive at any time whenever spot
rate is lower than the forward
 The net payoff would be positive at any time whenever spot rate is lower than the forward rate

Hedging Using Forward contracts for 3 month

If a 3 month forward contract is purchased with a rate of ARS 1.5 per USD and upon expiry,
the rate is ARS 2 per USD, then the net pay off would be positive at any time whenever spot
rate is lower than the forward

The net payoff would be positive at any time whenever spot rate is lower than the forward rate

Hedging Using Forward contracts for 6 month

If 6 month forward contract is purchased with a rate of ARS 1.5 per USD and upon expiry,
the rate is ARS 2 per USD, then the net pay off would be positive at any time whenever spot
rate is lower than the forward

The net payoff would be positive at any time whenever spot rate is lower than the forward rate

Hedging Using Forward contracts for 12 month

If 12 month forward contract is purchased with a rate of ARS 1.5 per USD and upon expiry,
the rate is ARS 2 per USD, then the net pay off would be positive at any time whenever spot
rate is lower than the forward

The net payoff would be positive at any time whenever spot rate is lower than the forward rate

Hedging unsing Put options for 1 month

ARS is expected to depreciate, once the peg is going to be removed, the Current rate of the
peso against the dollar is 1: 1 whereas after depreciation, it is going to be 2: 1.
In order to evaluate hedging with options, we assumed that we are buying put options for 1
month roll at a rate 1.5%, Also we assumed that the options are standerdized at $12 per
contract
 The net payoff would be positive at any time whenever spot rate is lower than the strike price

To conclude, it is worth the cost to increase the size of the GM's hedge position beyond
what was required by the Usual policy. It is obvious also that rolling shorter term contracts
( 1 month forward) Multiple times has better NetPayoff than purchasing long-year forward
contracts.