Passive Hedging Strategies for Foreign Exchange

The assignment delves into passive hedging strategies for managing foreign exchange risk. It examines the advantages of this approach, such as efficient risk budget utilization and access to foreign asset risk premiums without currency exposure contamination. The analysis uses General Motors as a case study, highlighting their long-term strategy and the implications of euro devaluation on their balance sheet. The assignment also considers the drawbacks of passive hedging, particularly its reliance on future cash flows and potential high costs associated with option contracts.

Que. 1 Explain and discuss the foreign exchange transaction exposure management by General
Motors by analysing data and information from the case study.
Answer:
General Motors (GM) operates all its foreign exchange operations from two plants and its
hedging activities were also concentrated with these two centers. First is the Domestic Finance
group in New York. This center handled FX hedging for General Motors entities located in
North, Latin and the Middle East of America and Africa. Second is the European Regional
Treasury Center (ERTC) and it is one of the large exchange operations of General Motors. This
center covers FX exposures of European and Asian continents’ countries.
While reviewing the corporate hedging policy of the company it is determined that overall
foreign exchange risk management policy was established to achieve primary objectives of the
company (Hawkins, 1995). First objective set by the company is to reduce the cash flow and
earnings volatility. Second objective, company need to reduce the management time and costs
used for global FX management. Thirdly, FX management is aligned in such way that it should
work consistent with GM’s automotive business. Regarding this context General Motors adopted
the passive policy where hedge is 50% of commercial or operating exposures. Company’s policy
also determined the sort of derivative instruments that were needed to use for hedging. Riskiness
was determined on the basis of region to decide which FX exposures were crucial enough to
warrant hedging.
Commercial (operating) exposures: Risk is determined on regional basis and it also decides the
significant FX exposures to warrant hedging (Bartram, Sohnke, Burns and Helwege, 2013). To
make this risk determination following formula is used
Implied risk = Regional motional exposure x Annual volatility of relevant currency pair
For example: The devaluation of euro (foreign exchange currency) may not have impact on
functional currency but there is different in the impact recognized in income statement and
shareholders’ equity.
Let us consider a case, where GM is investing in Japanese market. According to the rough
estimates of reports and marker research the automobile firms in Japan were run unprofitable

though yen was 110 and stronger than dollar. To become profitable Japanese firm need yen
value at 120 or more as compare to dollar. Japanese car has near about 20% to 40% Japanese
content and hence market share loss would equally affect its partnering organization. Rough
calculation implies that around 20% yen devaluation can capture an upper bound of the likely
foreign exposure. A consequent annual impact on GM's Income Statement could then be valued
as perpetuity at a 20% discount rate.
Commercial exposures (capital expenditures): Capital expenditure cannot be exhibited on
monthly basis for volatility or changing forecasts and hence General Motors have adopted a
unique approach to hedge capital expenditure. The planned investments which meet the
following two tests were hedged with forward contracts and the hedge ration used was 100% to
the anticipated payment date. The two tests are;
1) Amount in excess of $1 million, or
2) Implied risk equivalent to at least 10% of the unit net worth.
Financial exposures: The cash flows which incorporates loan repayment schedule and equity
injections need to be hedged on case-by-case basis and it is the main base of financial exposure.
Translation (balance sheet) exposures: This was not incorporated into the hedging policy of
General Motors
Accounting treatment: General Motors’s were constantly trying to reduce its earnings volatility
and it is one of the objectives of foreign exchange risk management policy. This is challenging
for GM to implement, because it requires that, according to the prevailing accounting standards
(FAS 133), GM income statement need to use marked-to-market and the gains and losses flow.
Qns 2) Explain and discuss (Using theories) the foreign exchange hedging strategies used
by General Motors for translation and economic (competitive) exposures.
Ans) The overall foreign exchange hedging policy of General Motors was established on the
basis of following objectives: -

1) For reducing the earning volatility and the cash flow.
2) For minimizing the costs of dedication to the global FX management and the time
consumption in the management process.
3) To align the management of FX in the way General Motors operates as its automotive
business.
Translational exposure
There is use of balance sheet hedge for typically mitigating the translation exposure as faced by
the General Motors Argentina. This theory requires an equal amount of foreign currency assets
and liabilities on GM’s consolidated balance sheet. There is a justification of the balance sheet
hedge: -
1) The use of local currency by the GM Argentina to use as a functional currency in that
country.
2) The operation of the company is on the basic of hyperinflationary environment.
This strategy is successful when it is depended on the precise prediction of the future exchange
rates. There is no possible future for such a hedge based on the future spot rates. It will
contribute in increasing the tax burden since the profit which gained from the forward hedge is
taxable.
Competitive exposure
It is the exposure which results in competing against companies with different currencies of
different countries. Like the Japanese automakers and the depreciation of the yen. The operation
of the company is affected by the risk of current and eroding market share and the value of the

market. There is a General Motors are competitive exposure to the yen is crucial to their profits
and the market share.
Qns 3) Do you agree with General Motors ‘foreign exchange hedging strategies why or why
not? Critically answer the question with supported data and information from the case and
by references to the text book.
Ans) Yes I agree with the hedging which the General Motors have used for foreign exchange
because it give them margin to gain. The contextual analysis tended to the presentation of
General Motors to the outside hazard that emerges because of its nearness at various geological
areas and exchanges in various remote monetary forms (Gounaris, 1997) . Corporate supporting
strategy exists in such manner however there are two unique cases that were tended to for the
situation contemplate. The matters require exceptional thought as the current strategy is not
particularly fitting to these two matters.
One matter is the organization's introduction to the outside trade chance emerges from Canadian
backup which has useful money USD so CAD is remote cash for this auxiliary. There are two
sorts of dangers that GM confronts in this circumstance; one is interpretation hazard and the
other one is exchange chance. The organization' is taking a gander at various supporting systems
to alleviate the dangers and managing the matter outstandingly from the organization's approach
(Bodnar, 2012). Keeping in mind the end goal to those extraordinary instruments (alternatives
and forward contracts) ought to be investigated for various level of support proportion in
addition to great and ominous situations. Interpretation dangers ought to likewise be talked about
and effect of them on salary explanation ought to be assessed.

The second matter is the administration significant interpretation chance emerging in Argentina
auxiliary because of late real cheapening in the neighborhood cash. A technique should be
assessed to manage this long haul chance.
CANADIAN DOLLAR HEDGING:
Forward rates contract is a well known and very utilized supporting instruments. It has its focal
points and impediments both. The principle inconvenience is that it is a coupling contract so
organization can't exploit great developments. It is normally utilized where organization is not
keen on increases rather immaculate supporting. Alternatives are choice to purchase or offer
specific money and they are normally costly than different instruments as they give preferred
standpoint of acknowledging upside presentation.
Distinctive supporting techniques for Canadian dollar hazard are utilized. Especially forward
rates contract and choices are utilized. The goal of our computation is to diminish the aggregate
sum paid by GM in regard of 1.7 billion CAD money to the providers. We first discover which is
the most gainful supporting instrument on half fence proportion then we appraise the aggregate
cost paid in utilizing 75% and 50 % support proportion.
Utilizing the case information given as a part of the contextual analysis we can evaluate the
aggregate cost that ought to be paid by the organization utilizing half support proportion.
The chart demonstrates that the choices are more beneficial at 1.6 trade rate.1.6 is the rate where
both lines cross each other. (Application 1)
Presently we can break down the wage articulation pick up/(misfortune) for the 2 situations for
both half support proportion and 75% fence proportion.

The level of misfortune and increase both are more in half support proportion when contrasted
with the 75% fence proportion and correspondingly the EPS unpredictability is likewise more in
75% when contrasted with half. The distinction is instability is because of larger amount of
vulnerability required in non supported sum. (Application 2)
Translational hazard is typically not supported by the organizations be that as it may if its effect
is critical on the income of an organization then supporting it is a more secure choice. Exchange
dangers ought to be supported if there is abnormal state of instability in remote trade rates as it is
on account of Canadian backup. Elective procedures can likewise be utilized by mesh off the
sum or utilizing fates however for that administration's opportunity will be an issue.
THE ARGENTINEAN PESO:
The case with the Argentinean backup is not like the first. The Argentinean government is
confronting huge monetary issues which tosses questions on its default. The nation has extremely
poor monetary circumstance without any changes and late degrading of cash has brought on the
supervisors to thoroughly consider the system that ought to be taken after. The supervisor
performed some supporting count however supporting is utilized where there is hazard as a part
of the fleeting and where chance can't be exchanged (Karolyi, 2006). For this situation where we
can without much of a stretch see that neighborhood coin is degrading with incredible pace we
ought to search for a long haul technique. Supporting methodology of GM ought not to be
modified in such manner however by different alternatives we can discover an answer.

Que. 4. General Motors describes its hedging strategy as “passive”. Is “passive” hedging strategy
compatible with shareholder value creation? Discuss the views for and against hedging foreign
exchange exposure.
Answer:
Is “passive” hedging strategy compatible with shareholder value creation?
The General Motor’s case study is analyzed here and how GM uses passive hedging policy is
determined. Within this policy the company hedged 50% of all its important foreign exchange
exposures. All FX exposures hedged by the company are arising from cash flows associated with
the current running business operations of the company. It is used to manage the risk and
provides a way for shareholders and investors to reduce the uncertainty occurred in the value of
foreign investments caused by exchange rate movements. Shareholders are encouraged to invest
in foreign with the desire to generate more returns on investment and achieve greater portfolio
diversification, but it also associated with market and currency risk (Bodnar and Gordon, 2012).
There is difference between currency and asset exposure and both are separate source of
volatility which generates no expected risk premium. Passive currency hedge is applied to
remove the unrewarded risk situation, particularly if company’s investment represents a
mismatch against future liabilities that need to be paid in the investor’s base currency. The
discussion evidence the importance of passive hedging strategy to shareholder value creation.
Views for hedging foreign exchange exposure:
Passive hedging provides an efficient and cost-effective solution for General Motors shareholder
through which they can manage currency risk. The passive solution has different forms which
incorporate the integrated trading, risk management, and reporting infrastructure. The passive
hedging program seeks to offer several advantages to company and its shareholders, given
below:
 Risk budget is used efficiently at the total portfolio level.
 The shareholder can get access to the foreign asset risk premium, without contaminating
any currency movement.
 Currency risk is managed directly which reduce volatility due to exchange rate moves.

 Hedging also protect the investment from foreign currency devaluation which impacts the
base currency.
 A low cost of implementation – Protection of the base currency value of foreign
investments for future liability payment
Among all financial markets, foreign exchange is the most liquid and large one and exposure
and risks associated with it are also high. The transaction cost of foreign exchange market is also
low while comparing it with asset markets. Moreover, in passive hedging shareholders can
participate in the trade execution.
Views against hedging foreign exchange exposure:
It is risky to use “passive” hedging because company completely depends on their future cash
flows through hedging a significant portion of their risk exposure. Hence, the highly risk-averse
companies would prefer to use the passive hedging policy. The passive hedging can be achieved
by freezing certain amount by creating long-term contracts between a supplier and buyer
(Karolyi, 2006). Another way of locking specific price is with the help of derivatives contracts
like futures, forward or swaps. These contracts are mostly available on leading commodity
exchanges. The General Motor’s finance executives were using forward contracts to hedge
exposure arising within six months. General Motor’s long-term strategy is providing good
options by allowing the company to either buy or sell in the target market without being
committed to hedge contract. Though this is good option of all time but it also obliges company
to face heavy hedging cost which is in the form of option premiums. These premiums have to be
paid up front at the time of hedging.
While viewing the balance sheet of General Motors it shows that adjustment has been done with
the equity of shareholders for translating to the US dollars of GMS’s assets. The critical
evaluation of this state that the devaluation of euro will not have impact on functional currency
but there is different in the impact recognized in income statement and shareholders’ equity.

References:
References:
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exchange rate exposure and stock returns in emerging and developed markets. Journal of
International Money and Finance, 31(4), pp.766-792.
Bartram, S.M. and Karolyi, G.A., 2006. The impact of the introduction of the Euro on foreign
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Bartram, S.M., 2007. Corporate cash flow and stock price exposures to foreign exchange rate
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