Prabhu Ramamoorthy – GM

GM Foreign Exchange Hedge

Date: November, 2008

Presented to: Jim Seward Raising Capital and Financing the Firm

Completed by: Prabhu Ramamoorthy

Recommendations

Increase hedge to 75% for hedging the Canadian exposure. The combined hedge percentage is to

account for both operational as well as balance sheet hedge due to monetary assets on the balance

sheet.

Hedge the Argentina position. Hard currency assets must be increased. Hedging can be done using the

forward rates of another reliable hard currency. Other natural ways to hedge would be through

commodities exports/imports done by Argentina.

Alternatives Considered and Ruled Out

Not hedge the monetary liabilities in the balance sheet of the Canadian subsidiary – Monetary liabilities

are without respect to future prices and this may create an exchange risk. So this has to be edged. Not

hedging this would be risky

Analysis

Hedging is necessary for a company such as GM. Appendix A provides arguments along this line.

GM has to revise its policies. It should analyze each transaction on a case by case basis. For transactions

that can be subject to high volatility, it is prudent to hedge a greater percentage of the nominal amount

of the transaction. The current hedging policy does account for this volatility in calculations of positions

to be hedged.

A hedging mechanism for such high volatile currencies ensures that the company does not lose money.

The policy must be changed to assess net balance sheet impact (consider monetary liabilities and

balance sheet effect also). This is because not only operational cash flow items but balance sheet items

such as monetary liability are also subject to exchange risk.

If you consider GM’s Canadian, the operational cash flows are 1,682 (Exhibit 9). Exhibit 10 also reveals

an insight on the balance sheet effects and the monetary liabilities which are subject to exchange rate

risk.

Prabhu Ramamoorthy – GM

Exhibit 11 shows the ARS Monetary liabilities which are subject to exchange rate risk. Both ARS

monetary assets and liabilities have to be hedged to prevent erosion of value. One way would be to

convert to other hard currencies in the near future.

Also it is reasonable to go for option positions which are not very long term. Hence 3 or 6 month

instruments would be a good way to reconsider the hedge going forward. You could periodically balance

them to remain neutral, unwind excesses or buy more protection.

Conclusions

GM’s policy must be revised. GM’s policy must be revised to consider balance sheet effects of exchange

rate risk also. Similar to operational hedging, a policy must be developed to support this risk also.

Appendix B discusses the reasons for this policy change.

Cumulatively when both the effects are considered operational and balance sheet, this signifies an

increase in hedging.

GM can also hedge more by way of options. Since options have a 50% delta (in the way in which GM

chooses it trades), you may allocate a bigger percentage to options. Hedging by the way of options

results only in premiums whereas hedging by way of forwards may call for a bigger notional amount in

the transaction.

Option volatilities may also be higher and it would be easier to balance a hedge based on options by

selling and buying them. Since the purpose of a hedge is to counteract this volatility, increasing the

option may be a policy change that GM can adopt. In this you could prevent rollover charges due to

futures.

Again this depends on a case by case basis and because of black scholes; you may have to pay a higher

for an option even when it is out of the money.

GM must also have a policy in place to prioritize its risk based on political, economic and technology risk.

Having such a policy will ensure that GM can predict volatility/uncertainty and put its hedge in place.

Prabhu Ramamoorthy – GM

Appendix A

Should Multinational firms hedge foreign exchange rate risk?

Multinational firms should hedge foreign exchange. This should be done to prevent

1) Cash flow effect of the foreign firm (if it is denominated in US dollars)

2) Decline in value of the equity holder due to adverse movements in exchange rates.

In both the cases, stock holder’s equity is impacted. Risk Management to manage earnings is very crucial

and unexpected losses due to not managing the risk may result in other expenses or failure to meet

earnings estimates. Exhibit 2 and Exhibit 3 reinforce the importance of hedging in GM’s case.

If not, what are the consequences?

Failure to hedge may result in cash flow being very volatile. Significant fluctuations in foreign exchange

distort the cash flow. The company’s cash flow from operations may be stable but exchange

losses/gains may lend an air of unpredictability to the net income statement and the shareholder’s

equity.

In many circumstances of political risk, exchange losses may lead to extraordinary losses also.

If so how should they decide which exposures to hedge?

The positions that should be immediately hedged are the ones which have a lot of uncertainty tied to

them. Example of this would be PESTLE

Political, Economic, Technology, Social Risk.

Companies can use derivatives and financial instruments to hedge the risk

One way would be is to hedge using the commodities market, futures and options.

An airline company may hedge fuel risk by hedging in the commodity. A multinational company with

lots of export/import may follow the same strategy.

Another strategy would be is to use futures, swaps, options and credit default swaps.

If currency appreciates, the seller of the option makes loss.

Exchange rates denominated in foreign currency/USD go up and the amount needed to purchase the

forward goes up.

If currency depreciates, the seller of the option makes a profit.

Exchange rates denominated in foreign currency/USD go up and the amount needed to purchase the

forward goes down.

Prabhu Ramamoorthy – GM

Appendix B

Should GM deviate from its policy in hedging its CAD exposure? Why or Why not?

Yes, GM should deviate from its policy to account for the balance sheet effect. Hedging must consider

this in addition to operational transactions.

If GMS does deviate from its formal policy for its Cad exposure, how should GM think about whether to

use forwards or options for the deviation from the policy?

GM may increase options in its hedge. This strategy allows GM to sell buy call/options to counter the

effects of the hedge. Rebalance, reassess remain delta neutral.

Why is GM worried about the ARS exposure? What operational decisions could it have made or now

make to manage this exposure?

GM is worried about its ARS exposure because of default and devaluation concerns. Moreover forwards

are predicting a high spike.Forwards are already considering this devaluation effect by prediction that

you could get more Pesos per dollar.

I would minimize ARS denominated assets and increase US hard assets. Hedge using labor. Can ARS

liability be hedged through way of commodities and other hedges. If yes ,explore this aspect.