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Foreign exchange hedging strategies at general motors

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Foreign exchange hedging strategies at general motors

  1. 1. www.futurumcorfinan.com Page 1 Foreign Exchange Hedging Strategies at General Motors Sukarnen DILARANG MENG-COPY, MENYALIN, ATAU MENDISTRIBUSIKAN SEBAGIAN ATAU SELURUH TULISAN INI TANPA PERSETUJUAN TERTULIS DARI PENULIS Untuk pertanyaan atau komentar bisa diposting melalui website www.futurumcorfinan.com
  2. 2. www.futurumcorfinan.com Page 2 Summary Overview of General Motors and its Treasury Operations General Motors General Motors was the world’s largest automaker, with unit sales of 8.5 million vehicles in 2001-15.1% worldwide market share-and had been the world’s sales leader since 1931. Founded in 1908, GM had manufacturing operations in more than 30 countries, and its vehicles were sold in approximately 200 countries. In 200, it generated earnings of $4.4 billion on sales of $184.6 billion. The labor costs for its 365,000 employees in that year amounted to $19.8 billion, only $8.5 billion of which was for U.S.-based personnel. In addition to vehicles, other major product lines included: (i) financial services for automotive, mortgage, and business financing, and insurance services through General Motor Acceptance Corporation (GMAC), (ii) satellite television and commercial satellite services through Hughes Electronics, and (iii) locomotives and heavy duty transmissions through GM Locomotive Group and Allison Transmission Division. GM traded on the New York Stock Exchange and was a component of the Dow Jones Industrial average. While North America still represented the majority of sales to end customers and the largest concentration of net property, plant, and equipment, the importance of GM’s international operations was growing as a percent of the overall business. With globalized production, these figures understated the degree to which intermediate goods in GM’s supply chain moved around the world. Its
  3. 3. www.futurumcorfinan.com Page 3 market share in Latin America was 20% and in Europe had reached 10% (20% and in Europe had reached 10% (20% if Fiat’s figures were included). Increasing market share in Asia, which stood at 4%, was a major strategic objective for GM. General Motors Treasurer’s Office Various groups within the Treasurer’s Office were involved in the implementation of financial risk management policy. For foreign exchange, all of GM’s hedging activities were concentrated in two centers:  The Domestic Finance group in New York handled FX hedging for GM entities located in North America, Latin America, Africa and the Middle East.  The European Regional Treasury Center (ERTC) was GM’s largest foreign exchange operation, covering European and Asia Pacific FX exposures. Review of Corporate Hedging Policy General Motor’s overall foreign exchange risk management policy was established to meet three primary objectives: 1. Reduce cash flow and earnings volatility. 2. Minimize the management time and costs dedicated to global FX management. 3. Align FX management in a manner consistent with how GM operates its automotive business. Passive Policy: Hedge 50% of Commercial (operating) Exposures
  4. 4. www.futurumcorfinan.com Page 4 GM policy also outlined what sorts of derivative instruments were to be used for hedging. Commercial (operating) exposures A determination of “riskiness” was then made on regional basis, deciding which FX exposures were significant enough to warrant hedging. This determination was governed by the following formula: Implied risk = Regional motional exposure x Annual volatility of relevant currency pair Commercial exposures (capital expenditures) Unlike uncertain cash flows, planned investments (purchases of fixed assets or equipment) that met either of the following two tests were hedged with forward contract using a 100% hedge ratio to the anticipated payment date: (i) amount in excess of $1 million, or (ii) implied risk equivalent to at least 10% of the unit net worth. Financial exposures Other certain cash flows, including loan repayment schedules and equity injections into affiliates were hedge on a case-by-case basis. Translation (balance sheet) exposures Translation exposures were not included under GM’s corporate hedging policy. Accounting treatment One of the goals of GM’s hedging policy was to reduce earnings volatility. This goal was challenging given that, under the prevailing accounting standards (FA 133), the forwards and options GM would use generally had to be marked-to- market and the gains and losses flowed through the income statement
  5. 5. www.futurumcorfinan.com Page 5 Reporting Hedging activities were closely tracked and regularly reviewed within the Treasury Group. Understanding the Choice of a Subsidiary’s Functional Currency When GMS instead uses its local currency (euros) as its functional currency, 1. GM’s consolidated income statement will include a gain or loss on the changes in value, as measured in GMS’s local currency of GMS’s non-local currency denominated asset/liability (GMS’s income statement will show the same). 2. GM’s balance sheet will show an adjustment to shareholders’ equity for the translation to U.S. dollars of GMS’s assets/liabilities. Implementing a Foreign Exchange Hedge When a hedge position was being created or modified, Mercedes Michel handled transactions in both forward and options contracts. Comparing Forward Contracts with Options Specifically, it compared: (1) the combination of the outright exposure plus a 50% hedge using forward contracts, with (2) the combination of the outright exposure plus a 50% hedge using options. Special Situations—the Argentinean Peso
  6. 6. www.futurumcorfinan.com Page 6 Credit analysts at Standard & Poor’s and Moody’s had downgraded Argentina to six and seven grades below investment grade, respectively. GM Treasury’s Latin America experts believed the short-term probability of default had reached 40%. In the medium term, the probability rose to 50% because Argentina had not addressed key issues such as trade liberalization, state reform, and pension and healthcare reform. Hedging the Peso Exposure GM Argentina had already eliminated peso cash balances and transferred them in USD to the European Regional Treasury Center. It was also considering the purchase of some materials locally in ARS for export to other entities on the region that would pay for them in hard currency. GM-Argentina’s USD borrowings would certainly have to be addressed. Understanding Competitive Exposures Source of Competitive Exposure This exposures was not created by GM’s inflows or outflows or how it chose to run its business. Rather, it was a result of competing against companies with different home currencies. As a result, any depreciations in the yen lowered their relative cost structure as compared to the U.S. and European auto manufacturers. Measuring Competitive Exposures
  7. 7. www.futurumcorfinan.com Page 7 There was no projected receivable or payable and no capital investment or loan to be repaid, yet there was still a bottom-line impact that stemmed from fluctuations in exchange rates. The two most difficult factors to estimate were the consumer sales elasticity and the cross elasticity to GM sales. A Place for Competitive Exposures in GM’s Corporate Hedging Policy? Unlike the CAD and ARS deviations, the yen exposures was simply more difficult to measure. In the context of a passive policy, implementing too many deviations might create a de facto active policy. What about the German car makers? Should euro exposures be measured too? Either way, the first step was getting a handle on the magnitude of the yen exposure. Conclusion Feldstein had a great deal of thinking to do. None of the three cases—the CAD deviation, the ARS deviation, or the JPY deviation— was a simple one. He was being asked to sign off on some very significant exposures, some in ways not necessarily contemplated by GM’s hedging policy. It was important for him to understand not just what the policy permitted, but hwhat the economics of each exposure were, and what was the best for GM as a consolidated global entity in each case.
  8. 8. www.futurumcorfinan.com Page 8 DISCUSSION 1. The Canadian Dollar There are two assignments from Eric Feldsten, Treasurer and Vice President, Finance for GM Corp. regarding GM Canada’s exposure to Canadian Dollar: 1. Feldsten needed a comparison of the income statement impact of a 75% versus a 50% hedge ratio. The proposal suggested that the expected volatility of the CAD/USD exchange rate was plus-or-minus 3.1% around the 1.5780 exchange rate on the date of the memo. Using this volatililty, Ostermann, FX and Commodities Manager, could do a sensitivity calculation with a favourable scenario (gain due to FX movements) and an unfavourable scenario (loss due to FX movements) based on the after-tax gain/loss impact from the projected CAD cash flow as well as from the CAD net monetary liability. Dividing this amount by the 550 million shares GM had outstanding, Ostermann could determine how much the proposed deviation would reduce EPS volatility. To simplify the calculation, Ostermann ignored the costs of hedging (such as option premiums). 2. Comparing forward contracts with options Specifically, it compared : (1) the combination of the outright exposure plus a 50% hedge using forward contract, with (2) the combination of the outright exposure plus a 50% hedge using options.
  9. 9. www.futurumcorfinan.com Page 9 First Analysis GM Canada projected Cash Flow Exposure Amount Sept. 30, 2001 (C$) 12 month C$ cash flow forecast - short 1,682.00 C$ Monetary net liability position - short 2,143.00 Total 3,825.00 Strategy I : 50% hedge ratio 3.1% drop Base case 3.1% up Exchange rate CAD/USD 1.531 1.578 1.627 12 month C$ cash flow forecast - short 1,682.00 Hedged portion: 50% over 12 month C$ cash flow forecast 841.00 532.95 532.95 532.95 Unhedged portion: 50% over 12 month C$ cash flow forecast 841.00 549.47 532.95 516.93 Sub-total 1,082.43 1,065.91 1,049.88 Difference from existing exposure - hedged/unhedged strategy (50% hedged) - negative indicating unfavourable to GM 1,065.91 (16.52) - 16.02 C$ Monetary net liability position - short 2,143.00 Not hedged 1,400.15 1,358.05 1,317.21 Difference because of FX movements - negative indicating unfavourable to GM 1,358.05 (42.10) - 40.83 TOTAL (58.62) - 56.86 (1.76) Probability (19.54) - 18.95 (0.59) Shares outstanding 550 Unfavourable EPS impact (0.00107) Strategy II : 75% hedge ratio on commercial exposure (approximately 30% hedging ratio for the balance sheet exposure) 12 month C$ cash flow forecast - short 1,682.00 Hedged portion: 75% over 12 month C$ cash flow forecast 1,261.50 799.43 799.43 799.43 Unhedged portion: 25% over 12 month C$ cash flow forecast 420.50 274.74 266.48 258.46
  10. 10. www.futurumcorfinan.com Page 10 TOTAL (58.62) - 56.86 (1.76) Probability (19.54) - 18.95 (0.59) Shares outstanding 550 Unfavourable EPS impact (0.00107) Strategy II : 75% hedge ratio on commercial exposure (approximately 30% hedging ratio for the balance sheet exposure) 12 month C$ cash flow forecast - short 1,682.00 Hedged portion: 75% over 12 month C$ cash flow forecast 1,261.50 799.43 799.43 799.43 Unhedged portion: 25% over 12 month C$ cash flow forecast 420.50 274.74 266.48 258.46 Sub-total 1,074.17 1,065.91 1,057.89 Difference from existing exposure - hedged/unhedged strategy (75% hedged) - negative indicating unfavourable to GM 1,065.91 (8.26) - 8.01 C$ Monetary net liability position - short 2,143.00 Hedged portion: 30% 642.90 407.41 407.41 407.41 Unhedged portion: 70% 1,500.10 980.10 950.63 922.05 Sub-total 1,387.52 1,358.05 1,329.46 Difference from existing exposure - hedged/unhedged strategy (30% hedged) - negative indicating unfavourable to GM 1,358.05 (29.47) - 28.58 TOTAL (37.73) - 36.60 Probability (12.58) - 12.20 (0.38) Shares outstanding 550 Unfavourable EPS impact (0.00069)
  11. 11. www.futurumcorfinan.com Page 11 Second Analysis Exposure in CAD million 20 Forward rate 1.4000 1.4500 1.5000 1.5500 1.5667 1.6000 1.6500 1.7000 1.7500 1.8000 Forward contracts - 50% hedged 50% 50% hedged 10 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 50% un-hedged 10 7.1429 6.8966 6.6667 6.4516 6.3828 6.2500 6.0606 5.8824 5.7143 5.5556 Total 13.5257 13.2794 13.0495 12.8345 12.7657 12.6328 12.4434 12.2652 12.0971 11.9384 Call Options contracts - 50% hedged Notional hedge amount 6.382843 50% hedged 10 0.0000 0.0000 0.0000 0.0000 6.3828 6.3828 6.3828 6.3828 6.3828 6.3828 Premium cost (1.45% of notional hedge amount) 1.45% (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) (0.0926) 50% un-hedged 10 7.1429 6.8966 6.6667 6.4516 6.3828 6.2500 6.0606 5.8824 5.7143 5.5556 Total 7.0503 6.8040 6.5741 6.3591 12.6731 12.5403 12.3509 12.1726 12.0046 11.8458 Difference forward - options contracts 6.4754 6.4754 6.4754 6.4754 0.0926 0.0926 0.0926 0.0926 0.0926 0.0926 Exchange Rate (CAD/USD) From the above analysis, it appears that call options looks more attractive then forward contracts, and more flexible.
  12. 12. www.futurumcorfinan.com Page 12 2. Special Situations – the Argentinean Peso Background of issue: Argentina government, in order to cure rampant inflation, has exercised control over foreign currency exchange and maintained a peg to the U.S. Dollar at USD 1 : ARS 1. With a debt-to-GDP ratio of 45% and $16.5 billion coming due in 2002, the ”zero-deficit” law passed by the Senate in 2001 put Argentina at serious risk of defaulting on its debt. A default would undoubtedly be accompanied by a massive devaluation. The GM treasury analysts expected a potential devaluation of the peso against the dollar from 1:1 to 2:1. Issue : 1. Local currency equivalent of USD borrowings by GM Argentina (a local currency functional subsidiary) would grow, putting financial pressure on the subsidiary. In fact, the $300 million USD net liability position would double in peso terms to an ARS 600 million liability. There would be a consequent ARS 300 million adverse income statement impact, as reflected in the loss on foreign exchange, for the subsidiary. 2. there would be a substantial translation loss on GM Argentina’s ARS denominated net assets when these net assets were consolidated in USD with all other assets of GM Worldwide.
  13. 13. www.futurumcorfinan.com Page 13 GM Argentina Balance Sheet, Monetary Assets and Liabilities by Currency A: 30 September 2001 ARS Monetary Assets ARS Monetary Liabilities Scrap incentive owned by government 45.80 Payables to local suppliers 24.10 Interest subsidy owned by government 3.20 Provisions to local suppliers 11.30 VAT credit and other tax owed by government 130.60 ARS loan (VAT financing) 13.70 Receivable (tax credit reimbursement) 2.70 Other provisions 9.80 Other 7.80 Tax payable 2.00 Total ARS Monetary Assets 190.10 Total ARS Monetary Liabilities 60.90 USD Monetary Assets USD Monetary Liabilities Cash 2.50 Accounts payable 224.50 Receivables 20.50 Loans 101.30 Total USD Monetary Assets 23.00 Total USD Monetary Liabilities 325.80 Total Monetary Assets 213.10 Total Monetary Liabilities 386.70 ARS net property, plant and equipment (assumption) 350.00 Stockholders' Equity 176.40 Common stock at 1:1 100.00 Retained earnings 76.40 Total Assets 563.10 Total Liabilities and Equity 563.10 First Problem faced by GM Argentina : Net USD Monetary Liabilities (325.80 - 23.00) 302.80 With likely devaluation of Peso to 2:1 Estimated loss on foreign exchange flowed through Statement of Income 302.80 Implication : Stockholders' Equity will become negative (126.40) Second Problem faced by GM Worldwide when consolidating GM Argentina Assuming using September 30, 2001 figures ARS Monetary Assets ARS Monetary Liabilities Scrap incentive owned by government 45.80 Payables to local suppliers 24.10 Interest subsidy owned by government 3.20 Provisions to local suppliers 11.30 VAT credit and other tax owed by government 130.60 ARS loan (VAT financing) 13.70 Receivable (tax credit reimbursement) 2.70 Other provisions 9.80 Other 7.80 Tax payable 2.00 GM Argentina Balance Sheet (ARS currency)
  14. 14. www.futurumcorfinan.com Page 14 With likely devaluation of Peso to 2:1 Estimated loss on foreign exchange flowed through Statement of Income 302.80 Implication : Stockholders' Equity will become negative (126.40) Second Problem faced by GM Worldwide when consolidating GM Argentina Assuming using September 30, 2001 figures ARS Monetary Assets ARS Monetary Liabilities Scrap incentive owned by government 45.80 Payables to local suppliers 24.10 Interest subsidy owned by government 3.20 Provisions to local suppliers 11.30 VAT credit and other tax owed by government 130.60 ARS loan (VAT financing) 13.70 Receivable (tax credit reimbursement) 2.70 Other provisions 9.80 Other 7.80 Tax payable 2.00 Total ARS Monetary Assets 190.10 Total ARS Monetary Liabilities 60.90 USD Monetary Assets translated to ARS using 2:1 USD Monetary Liabilities translated to ARS using 2:1 Cash 5.00 Accounts payable 449.00 Receivables 41.00 Loans 202.60 Total USD Monetary Assets 46.00 Total USD Monetary Liabilities 651.60 Total Monetary Assets 236.10 Total Monetary Liabilities 712.50 ARS net property, plant and equipment (assumption) 350.00 Stockholders' Equity (126.40) Total Assets 586.10 Total Liabilities and Equity 586.10 Total Liabilities in USD Dollar (divided by 2) 356.25 Common stock (assumption) 100.00 Retained earnings 76.40 Translation loss adjustment (239.60) Total Stockholders' Equity (63.20) Total Assets in USD Dollar (ARS balance/2) 293.05 Total Assets and Liabilities 293.05 Translated GM Argentina Balance Sheet GM Argentina Balance Sheet (ARS currency)
  15. 15. www.futurumcorfinan.com Page 15 From the above translated GM Argentina Balance Sheet in USD Dollar using Current Method, it is obvious that the stockholder’s equity of GM Argentina will suffer negative worth after the devaluation of ARS towards US Dollar from 1:1 to 2:1. Before devaluation, the equity indicates positive ARS176.4 and after devaluation, it reduces to negative ARS126.40. From the GM Worldwide consolidation level, there would be a negative impact to EPS after taking into effect of translation adjustment loss totaling US$239.60. Management of an USD Accounts Payable - assuming falling due within 90 days Hedging strategy: 1 Remain unhedged 2 Forward market hedge 3 Money Market Hedge US$224.50/(1 + (0.05 x 90/360)) USD Principal 224.50 USD investment rate per year 5% USD needed today 221.73 ARS needed at the current spot rate ARS1/US$1 221.73 ARS 221.73 x [1 + (0.12 x 90/360)] GM Worldwide WACC 12% Total cost of the money market hedge in ARS 228.38 To implement a money market hedge, GM Argentina would exchange ARS spot and invest them for 90 days in a US Dollar interest-bearing account. The principal and interest in US Dollar at the end of 90-day period would be used to pay the ARS accounts payable In order to ensure that the principal and interest exactly equal the US$224.50 due in 90 days, GM Argentina would discount the US$224.50 by the US$ investment interest rate of 5% (assumption) for 90 days in order to determine the US$ needed today: Finally, in order to compare the money market hedge outcome with the other hedging alternatives, the ARS 221.73 cost today must be carried forward 90 days to the same future date as the other hedge choices. If the current dollar cost is carried forward at GM Worldwide WACC of 12% (assumption), the total cost of the money market hedge is This cost is lower than the forward hedge and therefore attactive GM Argentina could wait 90 days, exchange dollars for ARS at that time and make its payment. The amount to be paid is uncertain and the spot exchange rate in 90 days could be very different from that expected. Assuming unbiased expectation prevails, the forward rate for 6-month is used to reflect expected spot rate for 90 days = ARS 1.350 to US$1, this strategy will cost ARS 303.075. GM Argentina could buy US$ 224.50 forward, locking in a rate of ARS 1.45 to US$ 1, and total ARS cost of ARS 325.525. This amount is ARS 22.45 higher than the expected cost of remaining unhedged and therefore clearly preferable to the first alternative. It was mentioned that this strategy will cost US$18.2mio for three-month forward, or resulting in total cost of ARS 343.725
  16. 16. www.futurumcorfinan.com Page 16 ARS 221.73 x [1 + (0.12 x 90/360)] GM Worldwide WACC 12% Total cost of the money market hedge in ARS 228.38 4 Option hedge US$ 224.50 x 0.015 x ARS1.40/USD 4.71 Strike price ARS to USD 1.40 Premium rate 1.50% 4.855935 Exercise call option (US$ 224.50 x ARS 1.40/US$) Strike price for call option 1.40 ARS 314.30 Call option premium (carried forward 90 days) 4.86 Total maximum expense of call option hedge 319.16 GM Argentina could cover its US$224.50 accounts payable by purchasing a call option on US$224.50. Assuming, a 90-day (December 2001) call option on US Dollar with a near at-the-money strike price of ARS1.40/USD would cost 1.5% (premium), or : This premium, regardless of whether the call option is exercised, will be paid up front. Its value carried forward 90 days at the WACC of 12%, would raise its end-of-period cost to ARS 4.86. If the spot rate in 90 days is less than ARS 1.40/US$, the option would be allowed to expire and the US$224.50 for the payable purchased on the spot rate. The total cost of the call option hedge if the option is not exercised is theoritically smaller than any other alternative (with the exception of remaining unhedged, because the option premium is still paid and lost. If the spot rate in 90 days exceeds ARS 1.40/US$, the call option would be exercised. The total cost of the call option hedge if exercised is as follows: Finally, in order to compare the money market hedge outcome with the other hedging alternatives, the ARS 221.73 cost today must be carried forward 90 days to the same future date as the other hedge choices. If the current dollar cost is carried forward at GM Worldwide WACC of 12% (assumption), the total cost of the money market hedge is This cost is lower than the forward hedge and therefore attactive
  17. 17. www.futurumcorfinan.com Page 17 Ending spot exchange rate (ARS/US$) Strategy 1 Strategy 2 Strategy 3 Strategy 4 Unhedged Forward Market Hedge Money Market Hedge Option Hedge 224.5 1.00 224.50 343.73 228.38 4.86 1.05 235.73 343.73 228.38 4.86 1.10 246.95 343.73 228.38 4.86 1.15 258.18 343.73 228.38 4.86 1.20 269.40 343.73 228.38 4.86 1.25 280.63 343.73 228.38 4.86 1.30 291.85 343.73 228.38 4.86 1.35 303.08 343.73 228.38 4.86 1.40 314.30 343.73 228.38 4.86 1.45 325.53 343.73 228.38 319.16 1.50 336.75 343.73 228.38 319.16 1.55 347.98 343.73 228.38 319.16 1.60 359.20 343.73 228.38 319.16 1.65 370.43 343.73 228.38 319.16 1.70 381.65 343.73 228.38 319.16 1.75 392.88 343.73 228.38 319.16 1.80 404.10 343.73 228.38 319.16 1.85 415.33 343.73 228.38 319.16 1.90 426.55 343.73 228.38 319.16 1.95 437.78 343.73 228.38 319.16 2.00 449.00 343.73 228.38 319.16 Cost in ARS to pay US$ 224.50
  18. 18. www.futurumcorfinan.com Page 18 The four hedging methods of managing a US$224.50 accounts payable for GM Argentina are summarized in below Exhibit. The costs of the forward hedge and money market hedge are certain. The cost of using the call option hedge is calculated as a maximum, and the cost of remaining unhedged is highly uncertain.
  19. 19. www.futurumcorfinan.com Page 19 For US Dollar-denominated loans totaling US$101.30, the Company could consider a number of strategies, assuming the loans payable to GM North America as a parent: 1. Replace US$-denominated loans to local currency ARS loans. This strategy could be actioned by:  having GM Argentina to obtain the same amount of ARS224.50 from local Argentine banks. However, perhaps it won’t be easy to get local Argentina banks to finance the refinancing from US$ to ARS, and if there is, the interest rate charged will be too high to accept.  having GM Argentina or through GM North America to use currency swaps.  Using parallel loans to hedge exchange rate risk. However, considering timeline, perhaps, this is not a good option, as it will take time to find a good Argentina company or party that is willing to provide simultaneous loans with an agreement to repay at a specified point in the future.  Having GM North America to be willing to convert the US$-denominated loans to be payable in ARS-based loans using current spot rate of 1:1. 2. Other strategy to explore is to have intracompany leads and lags which is more feasible in this case. 3. Balance sheet hedge approach by creating US$-denominated receivable, for example, by having GM Argentina to do exports to other GM affiliates, which could bring in revenues and creating receivables in US Dollar that will match the US$- denominated accounts payable and loans.
  20. 20. www.futurumcorfinan.com Page 20 Translation exposure Translation exposure for example, as faced by GM Argentina, is typically mitigated by using balance sheet hedge. A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on GM’s consolidated balance sheet. This balance sheet hedge is justified since : 1. GM Argentina is using the local currency as the functional currency. 2. GM Argentina is operating in a hyperinflationary environment In practice, some MNCs have attempted to hedge translation exposure in the forward market. Such action amounts to speculating in the forward market in the hope that a cash profit will be realized to offset the non-cash loss from translation. Success of this strategy depends on a precise prediction of future exchange rates, for such a hedge will not work over a range of possible future future spot rates. In addition, such a hedge will increase the tax burden, since the profit from the forward “hedge” (i.e., speculation) is taxable, but the translation loss does not reduce taxable income. Also, it is still highly controversial for a firm to expend resources and acquire hedging position with forwards and swaps to hedge accounting results. Assuming that balance sheet hedge is acceptable to GM management, GM management could either : 1. increase exposed ARS assets without simultaneously increasing ARS liabilities, or 2. reduce ARS liabilities without simultaneously reducing ARS assets.
  21. 21. www.futurumcorfinan.com Page 21 ARS Monetary Assets ARS Monetary Liabilities Scrap incentive owned by government 45.80 Payables to local suppliers 24.10 Interest subsidy owned by government 3.20 Provisions to local suppliers 11.30 VAT credit and other tax owed by government 130.60 ARS loan (VAT financing) 13.70 Receivable (tax credit reimbursement) 2.70 Other provisions 9.80 Other 7.80 Tax payable 2.00 Total ARS Monetary Assets 190.10 Total ARS Monetary Liabilities 60.90 USD Monetary Assets translated to ARS using 2:1 USD Monetary Liabilities translated to ARS using 2:1 Cash 5.00 Accounts payable 449.00 Receivables 41.00 Loans 202.60 Total USD Monetary Assets 46.00 Total USD Monetary Liabilities 651.60 Total Monetary Assets 236.10 Total Monetary Liabilities 712.50 ARS net property, plant and equipment (assumption) 350.00 Stockholders' Equity (126.40) Total Assets 586.10 Total Liabilities and Equity 586.10 Net exposed liabilities in ARS 126.40 Divided by exchange rate, ARS/USD 1.00 Net exposed liabilities in USD 126.40 times amount of devaluation 200% Expected translation loss under Current Method 252.80 GM Argentina Balance Sheet (ARS currency) Conclusion : the final hedging choice by GM management will depend on the confidence of ARS exchange rate expectations, and GM management’s willingness to bear risk. The money market hedge, if feasible in Argentina market, appears the preferred alternative. Otherwise, option hedge will be the second choice.
  22. 22. www.futurumcorfinan.com Page 22 3. COMPETITIVE EXPOSURE FROM JAPANESE AUTOMAKERS RESULTING FROM DEPRECIATION OF JAPANESE YEN Summary of Data Collected A 5% price increase could be expected to lower unit sales by around 10% A consequent annual impact on GM's Income Statement could then be valued as a perpetuity at a 20% discount rate Average Japanese car had between 20% and 40% Japanese content A reasonable etimate of what the Japanese automakers might give away in terms of added incentives or lower sticker prices would be between 15% and 45% of the cost savings Any market share losses to Japanese automakers would be shared equally among and entirely by the Big Three in Detroit. A rough calculation around a 20% yen devaluation would capture an upper bound of the likely exposure. Japanese automakers derived 56% and 43% of their revenues from the U.S Market in 1999 and 2000, respectively In recent year, they sold 4.1 millions units in the United States Equity analysts had estimated that the yen appreciation from 117 to 107 during the first half of 2000 had reduced Japanese automakers's combined global operating profits by $4 billion. Or reverse, for every 1 yen depreciaton against the dollar, Japanese competitors' collective operating profit grew by more than US$400 million Rough estimate from research reports suggested that the Japanese firms were unprofitable when the yen was stronger than110 to the dollar and profitable at 120 or more yen to the dollar
  23. 23. www.futurumcorfinan.com Page 23 Analysis Chain of events Data Collected Assumption Base Case Case 1 Case 2 Assumption for Base Case Pass through rate =30% Pass-through rate Pass-through rate 15% 45% (1) A depreciation in the yen lead to 100 Exchange rate (Yen/USD) 100 100 100 (2) additional gross margin for Japanese automakers, who For every 1 yen depreciation, Japanese competitors' collective profit grew by more US$400 million 400 1 Yen depreciation, cost savings (in million dollar) in terms of operating profit 400 400 400 (3) passed along some of this benefit to consumers in the form of lower prices, and Average Japanese content 20-40% and pass- through rate 15%-45% of the cost savings. 30% pass-through rate on cost savings : (in million US$) 120 60 180 (4) as a result of lower prices, the Japanese automakers gained market share in the U.S., which Cross elasticity to GM sales : a 5% price increase to lower unit sales by around 10%. Japanese automakers derived 56% and 43% of their revenues from the U.S. market in 1999 and 2000. Average incentive per unit in the US : Honda 664, Toyota 725 50% Cost saving impact of Japanese automakers to gaining bigger market share in US market - in million US Dollar 60 30 90 (5) ate into unit sales at GM, which any market share losses to Japanese automakers be shared equally by the Big Three 3 Shared equally by three 20 10 30 (6) lowered GM's profits, which Average net income to net sales of GM for the past three years 2.6% (see Exhibit 1 in the Case) 2.60% Impact to net income (on average 2.6% to net sales) 0.52 0.26 0.78 (7) reduced GM's market value Discount rate on income statement negative impact = 20% at perpetuity 20% Impact to GM's market value 2.6 1.3 3.9 From the above analysis, it appears that for every 1 Yen depreciation against the US dollar, GM will suffer the decline in its market value ranging from US$1.3 billion to US$3.9 billion.
  24. 24. www.futurumcorfinan.com Page 24 As noted in the Case Study that GM should place its estimated competitive exposure in the context of GM’s overall yen exposure. This included : 1. a commercial exposure based on forecasted receivables and payables of US$900 million 2. an investment exposure resulting from equity stakes in several Japanese companies Affiliate Affiliate Exposure Long/(Short) ($ billions) GM Ownership Stake Fuji (1.50) 20% Isuzu (1.02) 49% Suzuki (0.09) 20% 3. a financing exposure through a yen-denominated loan, totaling US$500 million of outstanding bond. In addition to the GM management’s efforts to lobby US Government to have a G to G discussion with the Japanese government in order to achieve a competitive exchange rate between Japanese Yen and US Dollar, GM management could consider diversifying its operations (and financing as well) in near future internationally, which will preposition GM management both to recognize disequilibrium when it occurs and to react competitively. Although the disequilibrium may have been unpredictable, GM management can often recognize its symptoms as soon as they occur.
  25. 25. www.futurumcorfinan.com Page 25 Recognizing a temporary change in worldwide competitive conditions permits GM management to make changes in operating strategies. Management might make marginal shifts in sourcing raw materials, components, or finished products. If spare capacity exists, production runs can be lengthened in one country and reduced in another. The marketing effort can be strengthened in export markets where the firm’s products have become more price-competitive because of the disequilibrium condition. Even if management does not actively distort normal operations when exchange rates change, the firm should experience some beneficial portfolio effects. The variability of its cash flows is probably reduced by international diversification of its producitons, sourching, and sales (and financing) beause exchange rate changes under disequilibrium conditions are likely to increase the firm’s competitiveness in some markets while reducing it in others. ~~~~~~ ####### ~~~~~~
  26. 26. www.futurumcorfinan.com Page 26 Disclaimer This material was produced by and the opinions expressed are those of FUTURUM as of the date of writing and are subject to change. The information and analysis contained in this publication have been compiled or arrived at from sources believed to be reliable but FUTURUM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. This document may not be reproduced either in whole, or in part, without the written permission of the authors and FUTURUM. For any questions or comments, please post it at www.futurumcorfinan.com © FUTURUM. All Rights Reserved

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