Case 1

Foreign Exchange Hedging Strategies at General Motors:

Transactional and Translational Exposures
The case is about the exposure of General Motors to the foreign risk that arises due to its presence at several
geographical locations and transactions in different foreign currencies.
In particular, it focuses on two matters:

1. The first is the company’s exposure to the foreign exchange risk that arises from the Canadian
subsidiary which has functional currency USD. There are two types of risks that GM faces in this
situation: translation and 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.

2. The second matter is the management major translation risk arising in the Argentinian subsidiary due
to the recent devaluation in the local currency.

The paper also explains that the overall foreign exchange risk management policy had to meet three
objectives: reduce the cash flow and earnings volatility, minimize the management time and costs dedicated
to the foreign exchange management and align it with the operating business.
Moreover, the hedging policy adopted was a passive one hedging the 50% of all significant foreign exchange
operating exposures on a regional level using both forwards and options.

However, GM’s FX team is evaluating whether they should increase or decrease the hedge ratio and they are
also evaluating whether to hedge by forward or options.

How functional currency affects GM bottom line?

Taking into consideration that the functional currency of the Canadian subsidiary is the USD, that is the
currency in which the company conducts its business and the reports, it affects GM bottom line because of
transactions adjustments.
As you remeasure each transaction made with the CAD into USD, the difference, gain or loss, flows through
the income statement as a foreign currency transaction adjustment. Net income is impacted as a result of the
remeasurement as it will impact the future cash flows of the company.

On the other hand, considering that the Argentinian subsidiary’s functional currency is the ARS, GM needs
to convert the Argentinian financial statements into the US dollar as of the end of the reporting period. This
is referred to as the translation adjustment and it is reported in the statement of other comprehensive income
with the cumulative effect reported in equity, as other comprehensive income. The translation adjustment
does not have any impact on net income.

Is GM “Passive” hedge policy reasonable?

GM passive hedging strategy implies the use of particular derivative instruments over specific time periods:
during the first 6 months of the fiscal year the company uses forward contracts to hedge 50% of the
exposures and during the last 6 months it uses options to hedge 50% of the exposures.

Throughout the passive approach, GM is neutralizing part of the risk that arises from the transaction
exposure created by the ongoing business operations. The choice to adopt this strategy is reasonable given
the amount of different currencies to which GM is exposed and also considering that the major part of GM’s
subsidiaries is using as functional currency the local one. Moreover, a passive hedging strategy is less
expensive than an active one.
What if GM changes its current passive policy from 50% to 90% hedge?

To change GM’s current passive policy from 50% to 90% hedge, there is the need to take into consideration
several factors. As it is shown in the table, using a hedging policy higher than 50% gives to the company
higher gains in case of currency appreciation but higher losses in case of currency depreciation.
Therefore, whether to change the hedging policy or not depends on different factors as:
- the volatility of the specific currency considered
- reliability of the expectations of the market
- the risk aversion of the company

What would be your recommendation to the GM team about their Argentine operation? (Hint: discuss
whether GM should hedge ARS exposure? If not, what other ways it could achieve similar goal?)

As written in the paper, the cost of forwards is increasing. In the Argentinian subsidiary case it is not
convenient for GM to hedge with derivatives, also because options are not to be considered as the currency is
depreciating.
In such difficult financial situations, the company should assess whether it is worthwhile to stay in
operations there as it may cause severe problems if it cannot withdraw its investments.

Other options to deal with the translational risk can be:

- to minimize it by borrowing in local currency (ARS) so that the level of payments remitted to the
parent is attenuated;
- or, the use of long term forex swap. This option is quite achievable for companies who have their
investments stuck up in countries from where they can’t withdraw the investment in the short-term.