General Motors Foreign Exchange Risk Management Policy Finance Essay - Free Essay Example

General Motors was the worlds largest automaker and since 1931, the worlds sales leader. In 2000, it had a net income of $4.4 billion on revenues of $184.6 billion. North America represented the majority of sales to end customers but international operations were also growing and international sales had reached 18% of overall sales. The key objectives of GMs foreign exchange risk management policy was to reduce cash flow and earnings volatility, minimize management time and costs dedicated to FX management and align FX management in a manner consistent with how GM operated its automotive business. GM hedged only cash flows (transaction exposures) and ignored balance sheet exposures (translation exposures). A passive hedging policy of hedging 50% of all significant foreign exchange exposures arising from receivables and payables was adopted. Forward contracts were used to hedge exposures arising within six months and options used to hedge exposures arising within seven to twelve months. GMs overall yen exposure included a commercial exposure based on forecasted receivables and payables of $900 million, an investment exposure resulting from equity stakes in Japanese companies and financing exposure through a yen-denominated loan. GMS COMPETITIVE EXPOSURE GMs competitive exposure to the yen arose because of competing against Japanese automakers who had large parts of their cost structure denominated in yen.Any fluctuation in the dollar/yen exchange rate affected the operating profits of Japanese automakers significantly, since they derived 43% of their revenue from the US markets (as of 2000). The yen appreciation from 117 to 107 during the first half of 2000 had reduced their combined global operating profit by nearly $4 billion. In the second half, the yen had begun appreciating. GM needed to quantify this competitive exposure and effectively hedge it. Depreciation of the yen would lead to reduced costs for Japanese automakers (since 20% to 40% content was sourced from Japan). 15% to 45% of this cost saving would be passed on to the customer. Customer sales elasticity as measured by GM indicated that a 5% price decrease would increase unit sales by around 10%. This market share gain by Japanese automakers would be shared equally and entirely by the Big Three in Detroit. QUANTIFYING GMS COMPETITIVE EXPOSURE Assumptions: ÂÂ ·Japanese car makers source 40% content from Japan (worst case scenario). ÂÂ ·45% of cost savings is passed on by Japanese carmakers to customers (worst case scenario). ÂÂ ·Yen devaluates by 20% compared to the dollar(worst case scenario). ÂÂ ·Total cost per car is $20000 (assumed). The margin obtained by GM is approximately $5900 ($1969 * 3) on the cost. Due to competition, Japanese carmakers would also need to price their vehicles similarly. Hence the same price is assumed for Japanese carmakers as well. ÂÂ ·Loss is valued as a perpetuity at 20% discount rate. Japanese carmakers General Motors Cost of Car $20,000 Price of car $25,900 Component cost (of Japanese component) at old exchange rate of $1=100 (40% components sourced from Japan) 800,000 = $8000 Component cost at new exchange rate of $1=120 800,000 = $6,666.67 Change in profit margin $1,333.33 Addl. Margin passed on to customers ( = 45% of change in profit margin) $600.00 New price of car $25,300 Price decrease 2.32% Increased sales (elasticity = 2) 4.63% Sales in 2000 4100000 Increase in sales in 2001 (Gain by Japanese carmakers shared by Big Three) 189962 -63321 Income loss for 2001 -$249,358,098 Income loss for perpetuity (Discounting at 20%) -$1,246,790,490 Thus the loss due to competitive exposure to GM is around $1.24 billion, which GM cannot afford to ignore. The above calculations have not taken into account any growth of the market or other variables. Also assuming that GM would not respond to a 20% change in exchange rates also may not be realistic. SENSITIVITY ANALYSIS A sensitivity analysis has been carried out, by varying the Yen/Dollar exchange rate from $1 = 120 yen to $1 = 80 yen. Also the content sourced from Japan has been varied from 20% to 40%. Varying these parameters, we get the values for income loss/gain for 2001. These values are discounted at 20% to find out the loss/gain to perpetuity. In this analysis, the margin passed on by Japanese carmakers has been fixed at 45%. Income loss/gain to perpetuity for GM with changes in exchange rate and Japanese content in Japanese carmakers automobiles: Exchange Rate: $1= 120 100 90 80 Japanese content 20% -$623,405,090 0 $415,596,830 $935,097,790 30% -$935,097,790 0 $623,405,090 $1,402,636,840 40% -$1,246,790,490 0 $831,193,660 $1,870,175,890 Another sensitivity analysis has been carried out, wherein the Japanese content in the automobiles is varied from 20% to 40% and the margin passed on by Japanese carmakers to customers has been varied from 15% to 45%. Here the exchange rate has been kept constant at $1 = 120 Income loss/gain to perpetuity for GM with varying Japanese content and margin passed on by Japanese automakers to customers: Japanese content 20% 30% 40% Margin passed on by Japanese carmakers to customers 15% -$207,808,260 -$311,712,390 -$415,596,830 30% -$415,596,830 -$623,405,090 -$831,193,660 45% -$623,405,090 -$935,097,790 -$1,246,790,490 In this case, value erosion ranges from -$208 million to -$1.25 billion REGRESSION ANALYSIS To calculate the effect of fluctuating yen-dollar exchange rate on the value of GM, a regression analysis can also be carried out. The coefficient of the exchange rate will indicate how much the value of GM changes. For example, if the coefficient is negative, it indicates that GMs value will decline as the yen depreciates relative to the dollar. However due to insufficient data in the case, this exercise has not been carried out. HEDGING POLICIES FOR COMPETITIVE EXPOSURE To hedge the competitive exposure to Japanese yen, GM can try the following strategies: ÂÂ ·Shift some of its production to Japan ÂÂ ·Source some parts from Japan However, these are long term strategies and need to be evaluated carefully taking into account market considerations. These decisions cannot be taken just for hedging purposes. GM currently follows a passive hedging policy which does not include guidelines on managing competitive exposure. All deviations from its current policy had to be approved by senior executives. An easier approach to manage the competitive exposure to the Japanese yen would be for GM to increase its yen borrowings (currently around $500 million worth of yen bonds are outstanding). This would serve as a natural hedge to any depreciation in the yen and would also not require the use of complex derivatives.