General Motors Hedging Case Paper – 6pages

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Professor Mihir A. Desai and Research Associate Mark F. Veblen prepared this case. HBS cases are developed solely as the basis for class
discussion. Certain figures and details have been disguised and do not reflect the actual operations of General Motors, Corp. Cases are not
intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2004 President and Fellows of Harvard College. To copies or request permission to reproduce materials, call 1-800-545-7685,
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photocopying, recording, or otherwise—without the permission of Harvard Business School.

M I H I R A . D E S A I

Foreign Exchange Hedging Strategies at General
Motors

In September of 2001, Eric Feldstein, Treasurer and Vice President, Finance for General Motors,
Corp. paid little attention to his unobstructed view of Central Park from his office far above the
Manhattan traffic. He had three risk management decisions to make: what to do about (i) GM’s
billion dollar exposure to the Canadian dollar, (ii) GM’s exposure to the Argentinean peso in light of
the expected devaluation in the months ahead, and (iii) the continuing strategic concern about
fluctuations in the Japanese yen, which figured so heavily into the cost structures of some of GM’s
competitors.

Feldstein and his treasury team were responsible for all of GM’s monetary transactions and for
managing the myriad risks associated with the timing of those transactions. They handled
everything from investing excess cash from vehicle sales receipts to hedging currency risks when a
foreign subsidiary like Opel Austria announced it would remit a dividend to the worldwide parent
company. The GM Treasury program invested heavily in its people, rotating them through
functional positions and offices around the world, developing their skills and experience. The unit
continued to produce individuals who went on to senior finance positions with GM subsidiaries or
elsewhere within the GM organization or left for senior roles at other major U.S. companies.

As GM expanded around the world, the magnitude of its exposures to foreign currencies grew.
Because exchange rate swings created gains and losses that flowed through GM’s reported income
statement, it was essential from a planning and management perspective to understand GM’s foreign
exchange flows and to manage the amount of earnings and cash flow volatility they imposed on GM.
Feldstein constantly followed news on volatile political situations around the world and kept abreast
of macroeconomic trends that might affect GM’s finances.

GM senior executives had implemented a number of formal policies with respect to foreign
exchange risk management and hedging procedures. These policies guided the vast majority of
treasury operations, but on occasion situations arose that required special attention and possibly a
deviation from the stated policy. Feldstein was reviewing proposals for the Canadian dollar (CAD),
Argentinean peso (ARS), and Japanese yen (JPY). He had the authority to sign off on each deviation.

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204-024 Foreign Exchange Hedging Strategies at General Motors

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Overview of General Motors and its Treasury Operations

General Motors1

General Motors was the world’s largest automaker, with unit sales of 8.5 million vehicles in
2001—15.1% worldwide market share—and had been the world’s sales leader since 1931. Founded in
1908, GM had manufacturing operations in more than 30 countries, and its vehicles were sold in
approximately 200 countries. In 2000, it generated earnings of $4.4 billion on sales of $184.6 billion
(see Exhibit 1 for GM’s consolidated income statement). The labor costs for its 365,000 employees in
that year amounted to $19.8 billion, only $8.5 billion of which was for U.S.-based personnel. In
addition to vehicles, other major product lines included (i) financial services for automotive,
mortgage, and business financing, and insurance services through General Motors Acceptance
Corporation (GMAC), (ii) satellite television and commercial satellite services through Hughes
Electronics, and (iii) locomotives and heavy duty transmissions through GM Locomotive Group and
Allison Transmission Division. GM traded on the New York Stock Exchange and was a component
of the Dow Jones Industrial Average.

While North America still represented the majority of sales to end customers and the largest
concentration of net property, plant, and equipment (see Exhibit 2 and Exhibit 3), the importance of
GM’s international operations was growing as a percent of the overall business. With globalized
production, these figures understated the degree to which intermediate goods in GM’s supply chain
moved around the world. Its market share in Latin America was 20% and in Europe had reached
10% (20% if Fiat’s figures were included2). Increasing market share in Asia, which stood at 4%, was a
major strategic objective for GM.

General Motors Treasurer’s Office

GM’s Treasurer’s Office performed a full range of corporate treasury functions from its head office
in New York and through additional locations in Brussels, Singapore and Detroit. The organizational
structure shown in Exhibit 4 demonstrates the nature and extent of those activities.

One of the key functions of the Treasurer’s Office was financial risk management. This included
management of not only market risk (foreign exchange, interest rate and commodities exposures) but
also counterparty, corporate and operational risk. Exhibit 5 outlines the components of this function
and demonstrates the high degree of centralization in approach.

All of GM’s financial risk management activities were subject to oversight by the Risk
Management Committee, which was composed of six of GM’s most senior executives including
Feldstein.3 The committee met quarterly to review the performance of GM’s financial risk
management strategies and to set treasury policy for GM and its subsidiaries. Treasury policy
included evaluating the parameters and benchmarks for managing market risks, determining criteria
for assessing counterparty credit risk, determining thresholds for property and liability insurance

1 Statistics drawn from General Motors, 2001 Annual Report (Detroit: General Motors, 2002) and General Motors, December 31,
2001 10-K (Detroit: General Motors, 2002)..

2 General Motors owned 20% of Fiat, and Fiat held an option to put the remaining 80% to GM.

3 Other members of the Risk Management Committee were the Chief Financial Officer, the General Auditor, the Chief
Accounting Officer, the Chief Economist, and a senior executive from General Motors Acceptance Corporation (GMAC), GM’s
financial services subsidiary.

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Foreign Exchange Hedging Strategies at General Motors 204-024

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coverage, as well as reviewing internal control aspects of operating policies and procedures. GM’s
formal, company-wide policies contained not only broad principles, but also detailed execution
procedures such as, in the case of foreign exchange risk management, the types of instruments to be
used and the appropriate time horizons.4 At its meetings the committee also discussed any special
topics that needed to be addressed. Such special topics often included precisely the deviations from
usual policy Feldstein was currently considering.

Various groups within the Treasurer’s Office were involved in the implementation of financial
risk management policy. For foreign exchange, all of GM’s hedging activities were concentrated in
two centers:

• The Domestic Finance group in New York handled FX hedging for GM entities located in
North America, Latin America, Africa and the Middle East

• The European Regional Treasury Center (ERTC) was GM’s largest foreign exchange
operation, covering European and Asia Pacific FX exposures

FX hedging activities were segregated in this way on the principle that there should be some
geographic correspondence between where a business unit was actually managed and where
treasury for that business was controlled. At the same time, though, it was considered desirable to
reap the benefits of pooling exposures across groups. In a sense, the goal was to match treasury
management to the footprint of the business. Having local market knowledge and a trading center in
both the European and U.S. time zones was also very helpful, because GM was active in each of the
major foreign exchange markets.

In managing the FX exposures, both the Domestic Finance group and the ERTC worked closely
with other groups within Treasury that had the primary responsibility of providing strategic support
to GM entities within that region. These groups were also the global coordinators for intercompany
loans, moved cash around the world to finance overseas mergers and acquisitions activities, and
managed dividend repatriations.

Review of Corporate Hedging Policy

General Motors’s overall foreign exchange risk management policy was established to meet three
primary objectives: (1) reduce cash flow and earnings volatility, (2) minimize the management time
and costs dedicated to global FX management, and (3) align FX management in a manner consistent
with how GM operates its automotive business. The first constituted a conscious decision to hedge
cash flows (transaction exposures5) only and ignore balance sheet exposures (translation exposures6).
The second objective was a consequence of an internal study that determined that investment of
resources in active FX management had not resulted in significantly outperforming passive

4 GM policy specified, for example, which risks were to be hedged using forward contracts rather than options contracts.

5 Transaction exposures are the gains and losses that arise when transactions are settled in some currency other than a
company’s reporting currency. These exposures stem from ing and selling activities as well as financing decisions such as
borrowing. For further detail see W. Carl Kester and Richard P. Melnick, “Note on Transaction and Translation Exposure,”
HBS Case No. 288-017 (Boston: Harvard Business School Publishing, 1987, rev. 1992).

6 Translation exposures are the gains and losses that arise when the assets and liabilities of a multinational’s foreign subsidiary
are translated back into the multinational’s reporting currency for the purposes of preparing consolidated financial statements.
For further detail see W. Carl Kester and Richard P. Melnick, “Note on Transaction and Translation Exposure,” HBS Case No.
288-017 (Boston: Harvard Business School Publishing, 1987, rev. 1992).

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204-024 Foreign Exchange Hedging Strategies at General Motors

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benchmarks. As a result, policy was changed and a passive approach replaced the active one. The
third reflected a belief that financial management should somehow map to the geographic
operational footprint of the underlying business.

Passive Policy: Hedge 50% of Commercial (Operating) Exposures

The policy adopted was generally to hedge 50% of all significant foreign exchange commercial
(operating) exposures on a regional level.7 GM policy differentiated between “commercial”
exposures—cash flows associated with the ongoing business such as receivables and payables—and
“financial” exposures such as debt repayments and dividends. GM policy also outlined what sorts of
derivative instruments were to be used for hedging.

Commercial (operating) exposures With operations, sales units, and investments spanning
the globe, GM had direct or indirect commercial exposures to virtually every meaningful currency.
Each regional center collected monthly forecasts of accounts receivable and accounts payable, usually
for the twelve coming months, from all of the GM entities within its region and totaled the net
exposures (receivables minus payables) by currency pair.8 This information was complied into a
matrix presenting the exposure totals by currency pair for each regional unit (General Motors North
America, General Motors Europe, General Motors Asian Pacific, and General Motors Latin America,
Africa, Middle East) and then aggregating them up to a corporate grand total for General Motors as a
whole. (See Exhibit 6 for the summary of exposures by currency pair.) In practical use, this provided
GM executives with granular information about the currency exposures created by ongoing business
operations.

A determination of “riskiness” was then made on a regional basis, deciding which FX exposures
were significant enough to warrant hedging. This determination was governed by the following
formula:

paircurrency relevant ofy volatilitAnnual exposure notional Regionalrisk Implied ×=

For example, if GM-North America’s forecasted 12-month euro exposure was a $400 million net
payable at December 31, 2000. This difference of euro receivables less euro payables would represent
the notional euro exposure for GM’s North America region. Give the Euro’s annual volatility versus
the U.S. dollar of 12%, this suggested an implied risk of $48 million. For all implied risks of $10
million or greater, the regional exposure was required to be hedged. In the case of particularly
volatile currencies, exposures were only hedged for the coming six months rather than twelve, and
the implied risk threshold was lowered to $5 million. In practice, GM’s overseas operations were
large enough that all major currencies exceeded this threshold in one or more regions.

Net exposures within a region were then hedged to a benchmark hedge ratio of 50%. For example,
half, or $200 million, of notional euro exposure of GMNA’s $400 million would be hedged.

7 The fact that exposures were managed regionally meant that although there might be offsetting exposures in different
regions, each region’s exposure would still be separately hedged. For example, if with respect to the British Pound GM-Europe
had a net receivables position $1 million and GM-Asia Pacific had a net payables position of $1 million, each region’s GBP
exposure would be hedged even though GM as a consolidated entity had no net exposure before or after this hedging activity
took place.

8 The business units were permitted some flexibility in netting across months so long as they established a currency hedge
through their treasury center. For example, if $20 million net receivables exposure in one month was likely to be offset by a $15
million payables exposure in the next month in the ordinary course of business, the net exposure of $5 million could be hedged
with a forward contract and a currency swap used to hedge the risk involved in the timing difference.

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Foreign Exchange Hedging Strategies at General Motors 204-024

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Having calculated the forecasted net exposure to a particular currency for each of the coming
twelve months, the regional treasury center was then bound to use particular derivative instruments
over specified time horizons: forward contracts to hedge 50% of the exposures for months one through
six and options to hedge 50% of the exposures for months seven through twelve. Assuming that
GMNA’s $400 million euro exposure was distributed evenly over the twelve months of 2001, the $200
million exposure for months one through six would be hedged through forward contracts on $100
million, and the $200 million exposure for months seven through twelve would be hedged through
options on $100 million. In general, at least 25% of the combined hedge on a particular currency was
to be held in options in to assure enough flexibility.

The evolution of the rolling forward twelve months naturally became more complicated when the
exposures were not evenly spread across time (see Exhibit 7). First, as months rolled closer (cash
flow G from month seven to six in Exhibit 7), the Treasury group replaced or supplemented options-
based hedge positions with forward contracts, sometimes selling options previously purchased. This
meant that the balance of forwards and options used to hedge the year ahead was constantly
changing—and according to policy, options had to make up 25% of hedge positions. Second, the
forecasts that the Treasury group received from managers in the operating subsidiaries frequently
changed from month to month. This created situations where hedging actions from the previous
month left the Treasury group either over- or under-hedged due to changing expectations.

Treasury centers were also expected to monitor the economic performance of their hedges and to
readjust cover to levels which matched the levels achieved by a simulated benchmark hedge
portfolio. This was done on a delta basis. The delta provided a measure of how effectively a
particular instrument covered a risk, taking into account the probability that the instrument would be
exercised. Forward contracts therefore had a delta of 100%. In purchasing currency options, GM
sought to at-the-money-forward options that had an expected delta of 50% upon execution.
Given the required mix of forwards and options in hedging an exposure, the hedge ratio of 50%
initially corresponded, on a delta basis, to a hedge ratio of 37.5%. Taking again GMNA’s euro
exposure as an example, the first six months were hedged on a delta basis at the notional hedge ratio
(50%) times the forward contract delta (100%) or a delta hedge ratio of 50%. Similarly the last six
months were hedged notionally at 50% and using options with a 50% delta, which combined to a 25%
delta hedge ratio. The average delta hedge ratio over the entire hedging horizon was therefore 37.5%
at the outset.

Over time, the delta hedge ratios of both the actual and the benchmark hedge portfolios could be
expected to depart from the initial 37.5%, primarily due to sensitivity of the value of options to
movements in spot rates. Experience suggested that the delta hedge ratio of the benchmark portfolio
would fluctuate somewhere between 30% and 45%. In addition, the delta hedge ratio of the actual
portfolio would often vary from that of the benchmark portfolio because of the practical difficulties in
executing exactly in line with benchmark. A tolerance of +/- 5% was therefore allowed in matching
the delta cover of the actual portfolio to the cover of the benchmark portfolio. It was also possible, on
an exception basis, to deviate from a passive hedging strategy and take a view on the future direction
of a particular FX rate. Regional approvals were required in any such case. Even then, delta and
notional cover levels had to be kept within certain prescribed ranges.

Commercial exposures (capital expenditures) Because capital expenditures did not exhibit
the same month-to-month volatility or changing forecasts, GM adopted a different approach to
hedging them. Unlike uncertain cash flows, planned investments (purchases of fixed assets or
equipment) that met either of the following two tests were hedged with forward contracts using a
100% hedge ratio to the anticipated payment date: (i) amount in excess of $1 million, or (ii) implied

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204-024 Foreign Exchange Hedging Strategies at General Motors

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risk equivalent to at least 10% of the unit’s net worth. Such exposures were generally treated
separately from ordinary commercial exposures.

Financial exposures Other certain cash flows, including loan repayment schedules and equity
injections into affiliates were hedged on a case-by-case basis. Generally they were structured so as to
create as little FX risk as possible, and as a rule of thumb they were also 100% hedged using forward
contracts. Dividend payments, on the other hand, were only deemed hedgeable once declared, and
even then were hedged in the same manner as ordinary commercial exposures, i.e. a 50% hedge ratio.

Translation (balance sheet) exposures Translation exposures were not included under
GM’s corporate hedging policy. At the same time, they could on occasion become large enough to
warrant the attention of senior finance executives, and Feldstein therefore kept abreast of any such
situations. Such exposures were closely related to management’s determination of a subsidiary’s
functional currency, a topic discussed below. Insofar as these exposures became significant and were
not covered by stated hedging policies, they took on increased importance.

Accounting treatment One of the goals of GM’s hedging policy was to reduce earnings
volatility. This goal was challenging given that, under the prevailing accounting standards (FAS
133), the forwards and options GM would use generally had to be marked-to-market and the gains
and losses flowed through the income statement. At the same time, the underlying exposure being
hedged was, in the case of commercial exposures (forecasts of receivables and payables up to 12
months in advance), often not on the books at all, and therefore changes in its market value did not
hit the income statement. This mismatch was a potential source of earnings volatility.

FAS 133, however, provided the possibility of hedge accounting treatment for an exposure and
associated hedge position. If the requirements for hedge accounting treatment were met, the above
described earnings volatility was neutralized by taking gains and losses on the hedges to a
shareholder’s equity account in the balance sheet pending the realization of gains and losses on the
underlying hedged exposures. Ultimately, gains and losses on the hedges would be released through
the income statement contemporaneously with the recognition in the income statement of the gains
and losses on the underlying exposures. Unfortunately, due to the complexity of compliance with
hedge accounting regulations only a few of GM’s more significant currency pairs were initially
targeted for compliance.9

Reporting Hedging activities were closely tracked and regularly reviewed within the Treasury
Group. The information was made available to senior management and to the Risk Management
Committee to assist in policy review and creation. It was this internal monitoring that had led, just a
few years earlier, to the decision to shift away from active FX risk management to passive
management.

Understanding the Choice of a Subsidiary’s Functional Currency

When U.S. multinationals established new overseas subsidiaries, management was required to
determine whether the functional currency for each overseas subsidiary would be the local currency
or the U.S. dollar. Under FASB #52, the functional currency had to be the primary operating currency
of that subsidiary. (There was one exception: parent companies were required to use their own

9 Compliance was voluntary: by providing extensive proof that derivative transactions were entered into for the purpose of
hedging and by establishing the effectiveness of the hedge, companies could obtain hedge accounting treatment for the
combined position and avoid asymmetric mark-to-market treatment of the underlying exposure and hedge position.

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Foreign Exchange Hedging Strategies at General Motors 204-024

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reporting currency in highly inflationary economies.) A self-contained unit with substantial local
currency receipts and expenses had to select the local currency as its functional currency. However, a
subsidiary that purchased much of its raw inputs from a U.S. parent or sold a substantial part of its
production to its U.S. parent each year—in short, operations that were essentially an extension of the
parent company’s business—had to select the U.S. dollar as its functional currency. The choice of
functional currency did not impact the consolidated entity’s reporting currency, which was always
the U.S. dollar in the case of U.S. multinationals.

While the choice of functional currency did not change the economic realities of the business and
its operations, it did change how a company reported the changes in value resulting from fluctuating
exchange rates. The following example illustrates the consequences of the choice of functional
currencies (see Exhibit 8 for an illustration of these issues).

Imagine that GM-Strasbourg (GMS) has nothing but cash held in a U.S. dollar-denominated
checking account and a euro-denominated checking account. The respective balances are $100
and �50. The subsidiary is financed entirely with equity. Furthermore, assume for simplicity
that the U.S. dollar and the euro are trading at parity. Suppose GMS has a choice whether to
use the U.S. dollar or the euro as its functional currency.10 The difference between these
alternatives is examined by tracing the consequences of a 10% devaluation of the euro against
the U.S. dollar.

When GMS’s functional currency is the same as GM’s reporting currency (U.S. dollars),
GM’s consolidated income statement will include a gain or loss on the changes in value, as
measured in U.S. dollars, of GMS’s foreign currency denominated monetary asset/liability.11
(GMS’s income statement will show the same.) When GMS instead uses its local currency
(euros) as its functional currency,

1. GM’s consolidated income statement will include a gain or loss on the changes in value, as
measured in GMS’s local currency of GMS’s non-local currency denominated
asset/liability (GMS’s income statement will show the same)

2. GM’s balance sheet will show an adjustment to shareholders’ equity for the translation to
U.S. dollars of GMS’s assets/liabilities.

The critical insight is that, while the overall impact of the devaluation of the euro will be the
same regardless of the functional currency chosen, there is a difference in what impact is
recognized in the income statement and what impact is recognized directly in the
shareholders’ equity of GM.

In the case where the dollar is chosen as the functional currency, the euro exposure is
considered the foreign currency. The illustrative 10% depreciation of the euro against the U.S.
dollar reduces the value of GMS’s euro holdings: the �50 that used to be worth $50 are now
only worth $45. This $5 loss is the economic impact on GM Worldwide (see Panel A in Exhibit
8 for an illustration). At the subsidiary level, that $5 loss is similarly recorded as a decrease in
value of the �50 that are held in the euro-denominated account. Both the subsidiary and GM
as a consolidated entity report on their income statements a foreign exchange loss of $5. This

10 As described above, the functional currency was determined by objective standards rather than a choice. This example
contemplates a choice of functional currencies for illustrative purposes.

11 For completeness, it should be noted that there would be an income statement impact resulting from any GMS foreign
currency denominated non-monetary assets such as inventory and fixed assets if the historical exchange rate at which these
assets were carried on the books needed to be adjusted retrospectively.

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