Foreign Exchange Hedging Strategies at General Motors - Essay Example

Homework 3 and 4 Lecture Sept 3 The current price of the Euro at 90 cents is higher in the United s since in one-year time the rate would gain 3 more cents for the same value of the dollar meaning the Euro would have lost its value by 3 cents. 2. a. The forward price of the pound for delivery 1 yr from now if F = S0erT Where (F = forward price, S0 = the spot price of the asset at time 0 and r is the risk-free interest rate) Current spot price of the British pound = $1.60 US Risk-free interest rate 1 yr government bonds = 4% UK Risk-free interest rate 1 yr government bonds = 8% The forward price of the pound in 1 yr = $1.60 * (1.04/1.08)1 = $ 1.54 b. How could an investor make risk-free arbitrage profits if the forward price were higher than the price you gave in answer to (a)? Please provide a numerical example. The investor can borrow then buy the British pound at $1.60 and hold it as the forward cost is zero initially. After one year, the investor sells the British pound using the forward contract and realizes $1.70 ($1.70 is an assumption of a forward price which is higher than $1.54) To repay the loan = $1.70 – $1.60 giving a profit of $ 0.1 3. a. Where would you lend? I would lend in the United Kingdom because the currency would attracts a higher interest rate of 7% as opposed to the United States with a lower interest rate of 4%. b. I would borrow in the United States as the cost of borrowing will be lower (four per cent) as compared to the United Kingdom whose cost of borrowing is seven per cent. c. Arbitrage can be done by borrowing in the UK at 7%, buying USD with the aim of investing it in the US at 4%, and sell the USD forward at 1.58 (one-year delivery). i. borrow, say $1m in the US @4%, payoff in one year would be $1,040,000 ii. buy British pounds, $1,000,000/1.60 = £625,000 iii. Invest £625,000 @7%, giving an annual payoff of $625,000*1.07 = £668,750 iv. Sell £668,750 forward at 1.60 = £668,750 *1.60 = $1,070,000 v. Payback loan in the UK for an arbitrage profit of $1,070,000- $1,040,000 =$30,000 d. F = S0erT Where (F = forward price, S0 = the spot price of the asset at time 0 and r is the risk) The forward price of the pound in 1 yr = $1.60 * (1.04/1.07)1 = $ 1.555 To calculate profit = $1.60 – $1.40 giving arbitrage profit of $ 0.20 CHAPTER 23 Questions 10-12 4. a. Transactional exposure is risk out of changes in currency exchange rates faced by companies that undertake international trade once they are under any financial obligations across countries. b. Transitional exposure is the risk out of currency exchange rate fluctuations that lead to changes of a firm’s assets, liabilities, or revenues especially through a foreign currency. c. Yes, multinational firms should hedge. Hedging will depend on weighted factors such as cost transaction and the amount of money vis-à-vis the foreign exchange rate that is subject to probable risk of fluctuating. Hedging helps multinational firms mitigate losses from translational and transactional exposures. Unfortunately, it may end up reducing gains as well. If multinationals companies do not hedge their foreign exchange rate risk, they become vulnerable to a myriad of losses, which may affect devastatingly their financial performance across the world. Various determinants motivate hedging. One is factors surrounding the organization operation such as time minimization, cost reduction, and aligning business strategies. The other critical factor is the investment resources used in foreign exchange management, which is used in determining the amount of currencies transacted. The commercial (operational) exposures and financial exposures determine shapes the risks to hedge. For example, GM had to hedge against receivables and payables, which are operational exposures of at the region and financial exposures such as paying dividend. d. Policy: General Motors foreign exchange hedging policy is streamlined to meet management objectives of efficiency and effectives in hedging e.g. minimize time, cost, and align foreign exchange management to automotive business. It is advantageous as it mitigates losses in transactional as well as translational exposures that are caused by fluctuating fx e.g. minimize cash flow as well as earnings volatility . The policy only controls fifty per cent of commercial exposure of a region as illustrated under the formula: Implied risk = Regional notional exposure x Annual volatility of relevant currency pair. Advice for changes: The hedge policy appears to be insufficient to cushion from most exposures. With the implied risk calculated on an annual basis, it is advisable for the company to extend hedging to cover 12 months rather than 6 months. In addition, the company should upsurge the exposure risk to over $ 5 million especially in the regions that have high volatility of foreign exchange rate of their currencies. e. Yes, GM should deviate from its hedging policy for CAD exposure, for the purpose of accounting for the balance sheet effect. f. GM should deviate from hedging CAD exposure. This is because Canada holds a significant production process and operations in GMNA region. As such, the CAD and USD FX have a significant impact on the financial results of GM. For example, year projected cash flow was CAD 1.7 billion which if not hedged could lead to a large deviation in GM end year financial results. According to General Motor’s hedge policy on CAD exposure, only fifty per cent of 1.7 billion is hedged. About CAD 0.85 billion is not hedged meaning the about is subject to transactional exposure which might lead to highly affected resulted when the CAD appreciates against the dollar. It is therefore critical that the cash flow exposures be mitigated more than 50%. g. The choice between forward or options is based on cost and volume of currency trading. In the beginning of a contract, an option is costly since it is bought at a premium. A forward contract attracts zero cost at the beginning of the trade. GM should settle on the contract with the least cost. Comparison can also be done based on outright exposure where choice of forward or options are considered based on prices. According to Michel these prices and cost indicated that forward and option prices had the same prices. In addition, option contract had an added premium cost of 1.45 % of hedging. This led to increased costs and reduced profit at the expiration of the contract. As such, they should consider the beginning and expiration of every contract. 5. when the USD strengthened against the pound sterling The impact of currency value disparity (fluctuation) is the main cause of Laker Airlines bankruptcy. In the case where the dollar strengthens against the pound, it means that less dollars will be given up for the same quantity of the pound. As such, it reduces the value of debt of the company in terms of pound sterling. When the amount of debt reduces in pound sterling it puts the company in a less worse position. Since all the revenues and debts are valued in pound sterling, it is easier to determine the position of Laker Airlines in terms of bankruptcy. Of which it is in a better off situation (Mihir & Veblen 2005). 6. a. GM is worried about the yen level because it has operations in Asia market too. Japan is the second largest economy in Asian market. Any fluctuations in the Japanese yen will pose an impact in the USDJPY FX. In addition, depreciation in the Japanese yen would mean that Japanese competitors would experience a reduction in costs, hence increased profit margins. This would, in consequence, allow the competitors to reduce their selling price and hence acquiring substantial market share. A case in point is where it is explained in the case that, “for every one-yen depreciation against the dollar, Japanese competitors’ collective operating profit grew by more than $400 million.” (Mihir &, Veblen, 2005, p. 113). b. How important is GM’s competitive exposure to the yen? The yen is a critical yen to GM since it features as a risk of exposure amidst competing companies that seek other currencies. All in a bid to reduce cost and enhance suitable valuation of their assets at market value. With many Japanese automakers, GM expects to take advantage of currency fluctuations and streamline their prices to consumer demand. Thus, offer their products at lower prices. The most important is the effect of competitive exposure to the market value of General Motors, which the yen exposure plays a significant role in valuation of variables and effects. Reference Mihir, A ., D & Veblen, M., F. (2005). Harvard Case: 9-205-095 Foreign Exchange Hedging Strategies at General Motors: Transactional and Translational Exposures. Harvard Business School Publishing, Boston Massachusetts. Read More