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?
Generally, multinational firms should hedge foreign exchange rate risk.
Because foreign exchange risk
1) Affects existing income statement items and balance sheet
assets, liabilities, and equity through translation exposure.
2) Influences the value of outstanding foreign-currency-
denominated contracts and obligations, thus firm’s earning and
cash flow through transaction exposure.
3) Impacts firm’s future revenues and costs, thus firm’s earning,
cash flow, enterprise value, and equity value through operating
exposure.
In order to reduce cash flow uncertainty and earning volatility, to
minimize negative impacts from foreign currency gain & loss on firm’s
value and equity, in most cases foreign exchange risk should be
hedged and exposures should be managed.

If translation exposure is not hedged, under FASB 52 the value of

financial statement items that translated at current exchange rate may
negatively affect consolidated earnings and equity value in case of
adverse exchange rate movements. If firms fail to hedge transaction
exposure, firms will face uncertainty in future cash flows and earnings
since foreign exchange swings tend to fluctuate cash flows and distort
earnings. If operating exposure is not managed, unfavorable exchange
rate changes may jeopardize or threaten firm’s competitiveness and
prospects thus affect profit margin, sale volume, and enterprise value.

Firms base on following factors to decide which exposures to hedge:

1. Significance of impacts. Firms may first determine how large will
exposures affect earnings, cash flows, and firm value by
analyzing exposure value, currency volatility, value at risk,
scenario analysis, sensitivity analysis, and etc. Only those
exposures have potentials to exert significant negative impacts
should be hedged.
2. Cost of hedge. Explicit costs such as option premiums and
implicit costs such management dedication and human resources
occupation associate with hedging specific exposure. Only hedge
those exposures with hedging benefits exceeds their costs.
3. Firm-based risk management policy. Multinational firms may
already establish matured risk management policy that
predetermines and prescribes the guild for which exposure to
hedge. Besides, firms may prioritize which exposure to hedge
first when conflicts arise from hedging different exposures.
3. Should GM deviate from its policy in hedging its CAD
exposure? Why or why not?
From exhibit 9 and exhibit 10, we observe that GM faced a transaction
exposure CAD 1.682 billion and a translation exposure CAD 2.143
billion. According to GM’s passive hedging policy, GM should hedge
50% of CAD 1.682 billion commercial exposure and ignore translation
exposure that stems from CAD 2.143 billion net monetary liabilities.
But FX & Commodities Manager proposed to increase hedge ratio to
75% for the commercial exposure.

The scenario analysis provided in Table 1 examines the impact of 75%

hedging versus 50% hedging on the GM’s income statement and
earning per share under plus-or-minus 3.1% movement of current
exchange rate 1.5780. Since commercial exposure is the present value
of estimated future 12 months cash flows, it has no instant effect on
current financial statements. Only the hedge position created and
translation exposure affect current earning.

According to the analysis presented in table 1, we find that hedge 75%

of commercial exposure will largely reduced net income volatility and
EPS volatility (32.03% reduction). Therefore we recommend GM to
deviate from its current policy and approve 75% hedge for the CAD
1.682 billion exposure.

We also observe that by increasing the hedge position for transaction

exposure, GM actually is “hedging” the translation exposure
effectively. Because the impact (on earning) from the long CAD hedge
position partially cancels out the impact (on earning) from the short
CAD translation exposure. If the GM considers it’s desirable to
minimize translation exposure in order to reduce its effect on year-end
financial result and neglect hedging cost, 100% hedge position for
commercial exposure will further smooth earning and reduce earning
volatility by 64.59%, based on the analysis in Table 2.
Table 1
From the consolidated income statement, we estimated the
tax rate.
Year 2000 1999 1998
EBIT 7164 9047 4944
Income tax 2393 3118 1636
Tax rate 33.40% 34.46% 33.09%
Tax rate average 33.65%
CAD/US +3.1% - 3.1%
hedge ratio 50%
D USD USD
commercial exposure C$
1.5780 1.6269 1.5291
(million) -1,682
hedge position (million) C$ 841 $532.95 $516.93 $550.00
- -
net monetary liabilities C$
$1,358.0 $1,317.2 -$1,401.49
(million) -2,143
5 1
Gain/Loss on hedge position (million) -$16.02 $17.05
Gain/Loss on translation exposure
$40.83 -$43.45
(million)
Effect on earning before tax (million) $24.81 -$26.40
Effect on net income
$16.46 -$17.51
(million)
Effect on EPS (dollar per share) $29.93 -$31.84
CAD/US +3.1% - 3.1%
hedge ratio 75%
D USD USD
commercial exposure C$
1.5780 1.6269 1.5291
(million) -1,682
C$
hedge position (million) $799.43 $775.39 $825.00
1,262
- -
net monetary liabilities C$
$1,358.0 $1,317.2 -$1,401.49
(million) -2,143
5 1
Gain/Loss on hedge position (million) -$24.04 $25.58
Gain/Loss on translation exposure
$40.83 -$43.45
(million)
Effect on earning before tax (million) $16.80 -$17.87
Effect on net income
$11.14 -$11.86
(million)
Effect on EPS (dollar per share) $20.26 -$21.56
50% 75%
reduction effect
hedge hedge
volatility(range) of NI 33.97 23.00 32.30%
volatility(range) of EPS 61.77 41.82 32.30%