Gm Case Study

1) Should multinational firms hedge foreign exchange rate risk? If not, what are the consequences? If so, how should they decide which exposures to hedge?

Multinational firms do business in various countries in various forms (import/export, subsidiaries abroad, etc.). When these business activities involve currencies other than the home (domestic) currency, the company is also exposed to the risk of fluctuations in the foreign exchange rates. The three main types are (cf. Shapiro, 1996; Madura, 1989):

- Transaction risk (involving all incoming or outgoing cash flows). As a result, the consequences of not hedging this risk are potential devaluations of a business transaction as follows: (1) Less money is received from a paying party due to unfavorable FX rates, or, (2) more money needs to be paid to a delivering party due to unfavorable FX rates. Note that the appreciation of a transaction’s worth due to FX movements is generally not a prior concern to hedge, as more money or less cost is economically desirable to companies.

- Translation risk (affecting the balance sheet and “as-is-situational” valuation). Exchange rate movements could potentially devalue a foreign subsidiary and given the underlying financial statement consolidation practices of a MNE, have a devaluating effect on the entire holding, also.

- Economic risk (the risk of future cash flows present values affected by exchange rates). Not hedging this exposure could lead to misevaluations of investment and strategic decisions as well as unanticipated results and outcomes.

However, the hedging debate is not a no-brainer. Even though the economic benefits seem obvious, there are some questions to consider:

1. Does it make economic sense? That is, are the costs of hedging larger than the costs of not hedging? These costs not only include transaction costs, but reporting, treasury, accounting, human resources, aka fixed costs can add up quickly, especially for more sophisticated instruments that require more maintenance and attention. These costs might be amortized easily by large multinationals, but smaller enterprises might not be able to afford these.

2. Firms also need to be aware of the country-specific regulatory requirements to hedging with derivative instruments. This is especially true post-financial crisis when a lot of regulatory authorities have revised their frameworks and accounting standards for enterprises.

3. Can it be executed correctly? Hedging needs to be done right and thus, there needs to be skilled experts in the treasury departments as well as in the relevant risk committees that set the hedging policies.

4. Can it be disclosed and made comprehensible to all involved agencies (investors, executive management, risk commissions, supervising boards) and can all parties stand behind the hedging approaches? This included psychological considerations as the term