Two Main Types of Currency Exposure

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General Motors was the world’s largest automaker and, since 1931, the world’s sales leader. In 2001, GM had unit sales of 8. 5 million vehicles and a 15. 1% worldwide market share. Founded in 1908, GM had manufacturing operations in more than 30 countries, and its vehicles were sold in approximately 200 countries. In 2000, it generated earnings of $4. 4 billion on sales of $184. 6 billion. The company is trying to accurately calculate the risk of a potential devaluation to the ARS.

In doing so the company had to decide between two options on how to proceed; was it worth the costs to increase the size of GM’s hedge position beyond the standard policy or should GM Argentina rely on other approaches to cope with the expected devaluation? Appraisal of GM’s Passive Hedging Strategy GM’s passive hedging strategy is reflective of its policy to focus on its underlying business rather than speculate on the movements of foreign currency. There are two main types of currency exposure. The first being economic risk.

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This deals with the impact of devaluation on the present value of the future earnings of the firm. It is very difficult to measure this concept because it depends on the reaction of the competitive context of the firm and the effect of the currency shock over competitors and customers. The second risk is the transaction exposure which is easier to measure and to hedge. Translation exposure or cash flow exposure concerns the actual cash flow involved in settling transactions denominated in foreign currency.

Firms seldom hedge against balance sheet or translation exposure for two reasons; devaluating in one currency could be compensated with revaluation in another and in the long term assets and net worth would not be affected by currency volatility because exchange rate movements mainly depend on productivity. GM’s current policy is to hedge 50% of all significant foreign exposure on a commercial level. The majority of volatility reduction is achieved with the first 50% of hedging, after which the pace of risk reduction diminishes quite quickly.

From a behavioural finance perspective a %50 hedge is the position of least regret for short term fluctuations i. e. could have been better, could have been worse In our opinion GM is in general hedging too much using financial instruments which is a costly method. The company could look into internal hedging i. e. leading and lagging or commodity hedging. Natural hedging is also an option which is also discussed later in our report. They also hedge regionally where they should have a centralised hedging policy where the residual risk can be calculated and hedged.

We would advise GM to not use an active hedging strategy as their focus is on selling units and not making a profit from currency management. It is clear from their risk management objectives that they are risk averse. Their interest is in stable cash flows and not speculating on the volatility of currencies which is represented in their use of a passive strategy. Hedging decisions need to be placed with the centralised Risk Management Committee. This will allow GM to maximise netting opportunities while minimising idle balances in non-functional currencies.

It is also beneficial for parent treasuries to be assisted by foreign hedging centres that relay information back to headquarters. Even companies that do not have centralised FX risk management undertake various activities to reduce individual FX trading among the operating units. ‘For example, if with respect to the British pound GM-Europe had a net receivables position $1 million and GM-Asia Pacific had a net payables position of $1 million, each regions GBP exposure would be hedged even though GM as a consolidated entity had no net exposure before or after this hedging activity took place. (Note 8) Such problems would be eliminated using a centralised approach Under what circumstances should GM deviate from its formalized hedging policy? Managing a firm’s foreign currency exchange exposure accurately requires in general, a company-wide formal currency risk management strategy. Usually, the most common risk management strategies can be subdivided into multi-stage approach in order to obtain a better impression of the underlying risks and thus to increase the probability of mitigating the firm’s risks properly and successfully.

Also General Motors Corporation has developed various rules and guidelines to help manage minimize the risks associated with their business and investment operations. The first stage in defining a risk management strategy includes the formulation of superior objectives as basis for the firm’s foreign exchange risk management policy. Only with respect to these objectives embedded in the firm’s risk management strategy can an appropriate policy in managing foreign currency risks be developed.

For instance, GM Corporation has identified three primary objectives which should be met by the foreign exchange risk management policy to ensure the ongoing business results. 1) Reduce the volatility of cash flows and earnings in foreign currencies 2) Minimize the cost associated with the foreign exchange risk management strategy, i. e. the management and hedging costs 3) Align foreign exchange management in a manner consistent how GM Corporation operates its automotive business According to these it can be concluded that GM Corporation’s risk management policy is based on a mostly passive hedging strategy.

In general, passive hedging is used by highly risk-averse companies that would like to be completely certain of their future cash flows through hedging a significant portion of their risk exposure. In contrast to an active hedging policy, a passive hedging policy is not be used to enhance returns. Therefore, GM Corporation’s treasurers are not allowed to benefit from exposure to appreciating foreign currencies. Furthermore, the formulated objectives imply that balance sheet exposure or translation exposure, respectively, are completely ignored within GM Corporation’s foreign exchange risk management policy.

Here the essential assumption could be that multinational companies, like GM Corporation, having business in many countries and regions are able to compensate the impact of currency volatility in the value of assets and liabilities through devaluation in one currency with revaluation in another. Derived from the identified firm specific primary objectives relating to the foreign exchange risk management policy, the actual risk management process can be developed at a second stage. In general, there are four key steps that firms should take to manage their underlying currency risks accurately: FIGURE! 1.

Risk Identification Identify and analysis the type of currency risk to be managed, i. e. transaction exposure 2. Risk evaluation Measurement methodology, i. e. create a model to measure the currency exposure to be managed and calculate exposure 3. Risk mitigation Covering strategy, i. e. determine to what extent and how exposure will be hedged and hedge execution, i. e. hedge exposure through trade execution and other techniques 4. Risk monitoring risk control and continues measure of hedging performance Also GM Corporation follows the four-step risk management process as can be seen in the following paragraphs. . Risk identification The most critical step within the risk management process is to identify all possible scenarios where uncertainty exists. GM Corporation has identified two categorize in which all significant risks can be addressed. Commercial exposures being the first risk-category include cash flows associated with the ongoing business; however financial exposures as a second risk-category contain debt repayments and dividends. 2. Risk evaluation Based on the risk identification, both risk categories have to be assessed objectively in terms of their individual impact and probability.

The primary aim of the risk evaluation is to define a ranking of risks on a regional basis. The determination of the riskiness of commercial operating exposures is defined by the following equitation: Implied risk=Regional notional exposure*Annual volatility of relevant currency pair For all implied risks of $10 million or greater, the exposure is significant enough to be hedged for the coming twelve months. However, the implied risk threshold of more volatile currencies is lowered to $5 million or greater and is only hedged for the coming six months.

In order to analyze the commercial exposures of capital expenditures GM Corporation uses a different approach. All investments which either have an amount in excess of $1 million, or an implied risk threshold of at least 10% of the unit’s net worth have to be hedged. However, financial exposures have no defined thresholds and are evaluated on case-by-case basis. 3. Risk mitigation After evaluating the different kinds of risks to define the risk priority, several hedging techniques can be used to minimize the firms’ currency exposure. There are two primary ways in which companies can protect themselves from currency risk.

The first is through natural hedging and the other is financial hedging. GM Corporation, however, operates only with financial hedging instruments, i. e. with Forward contracts and Options. What types of hedging instruments are appropriate for GM? Should the same instruments be used in all situations? There are many ways to hedge foreign currency risks. There are internal tactics such as leading and lagging, as well as external strategies such as forwards, futures, swaps and options. GM use forwards and options as their hedging instruments. Internal Hedging Strategies Leading and Lagging

Internal strategies such as leading and lagging can ensure that firms use exchange rate movements to ensure that they always pay less and earn more. To ‘lead’ means to pay or collect early, whereas to ‘lag’ means to pay or collect late. A trader can lead or lag (pay late) his foreign currency payments, depending on whether he anticipates the foreign currency to appreciate or depreciate. The idea is that home currency appreciation (foreign currency depreciation) translates into lower receipts and higher payments, respectively. Similarly netting the payments and receipts that are in the same foreign currency will also help reduce the exposure.

Hedging through Invoice Currency Hedging through forwards, futures, swaps and options are fundamentally well-known hedging instruments. However hedging through the use of invoice currency is a hedging technique that has not been fully exploited. The firm can shift, share or diversify currency exchange rate risk by choosing the currency of the invoice. Shifting the currency exchange risk does not cause the exchange exposure to disappear it simply shifts to the counterparty. Instead of shifting the exchange exposure, firms can agree to share to exposure.

This can be achieved for example if half of the bill is invoiced in one currency and the other half in another currency. Only a firm of substantial market power can use the shifting or sharing approach as a firm with low market power would face the risk of losing sales. A firm can also diversify their exposure by using a currency basket such as the SDR (Special Drawing Rights). The SDR is a portfolio of currencies, the U. S. dollar, the euro, the Japanese yen and the British pound. As the SDR is an accumulation of currencies, its value should be substantially more stable than the value of an individual currency.

External Hedging Strategies Forward Contracts Hedging currency risks with forward contracts is the most direct and popular way of hedging transaction exposure. A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. The currency payment or receipt is locked in at a particular exchange rate for a pre-specified rate in the future, irrespective of what the spot exchange rate at that time is. The idea behind forward contracts is that as the exchange rate is locked on both sides, both, the creditor and the lender do not have to worry about fluctuations, thus creating certainty.

Future Contracts Future contracts are similar to forward contracts in the respect that a certain currency will be exchanged for another at a specified time in the future at prices specified today. The advantage that currency futures have over currency forwards is that as these are exchange traded, counter-party risk is eliminated as a clearinghouse provides guarantee against default. It also helps that currency futures are more transparent in their pricing and are more easily available to all market participants. Futures have a number f standardised features such as the: Contract Size, Delivery Month, and Daily Resettlements. The main advantage of futures over forwards is the ability to liquidate before the maturity date. Swap Contracts Swap contracts are real time exchange rate transactions where one thing is just exchanged for another. Swap contracts are useful for firms that often have to deal with a sequence of accounts payable or receivable in terms of a foreign currency. An agreement is made to exchange one currency for another at a predetermined exchange (the swap rate) on a sequence of future dates.

Swaps are essentially a series of forward contract with different maturities. Currency Options Currency options are financial instruments that give the owner the right but not the obligation to buy or sell a specific foreign currency at a predetermined exchange rate. A call option gives the holder the right to buy the currency at an agreed price. A put option gives him the right to sell it at an agreed price, irrespective of an unfavourable market price. Essentially currency options provide a flexible “optional” hedge against exchange exposures. General Motors use two hedging instruments – forwards and options.

As discussed in question 1 their hedging policy consists of 50% forwards and 50% options. The same instruments should not be used in all situations. For more risky situations GM should use a higher percentage of options as although more expensive they offer more flexibility. For less risky situations i. e. when the currency market is stable and predictable GM should use forwards as they are less expensive. GM should also look at other alternatives such as hedging through invoice currency and lead and lagging for extraordinary circumstances – these will be discussed further later in the report.

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Two Main Types of Currency Exposure. (2017, Feb 17). Retrieved from

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