General Motors Foreign Exchange Risk Management Policy Finance Essay

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General Motors was the world's largest automaker and since 1931, the world's 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 GM's 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.

General Motors was the world's largest automaker and since 1931, the world's 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 GM's 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.
GM's 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 yendenominated loan.

GM'S COMPETITIVE EXPOSURE

GM's 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 GM'S COMPETITIVE

EXPOSURE

Assumptions:

Japanese car makers source 40% content from Japan (worst case scenario).

45% of cost savings is passed on by Japanese carmakers to customers (worst

case scenario).

Yen devaluates by 20% compared to the dollar(worst case scenario).

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.

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 GM's 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:

Shift some of its production to Japan

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.