Question

General Motors (GM) is buying some parts from a European factory. Specifically, GM has ordered 2000 engines to put in Chevrolet Silverado pickup trucks it plans to produce at its US assembly plants. Each pickup truck engine is priced at 2500 EUR and GM will pay the European factory for the 2000 engines in 2 months. The current spot rate is 1 USD/EUR and the two-month forward rate $1.1 USD/EUR.

Is this foreign exchange rate exposure best described as transaction, translation or operating exposure for GM? Why? How can GM hedge this exposure to foreign exchange risk? Explain why the strategy works

URGENT

Answer 1

Is this foreign exchange rate exposure best described as transaction, translation or operating exposure for GM? Why?

~ This foreign exchange rate exposure is best described as Transaction Exposure for GM.

~ Transaction exposure arises from the effect that exchange rate fluctuations have on a company’s contractual obligations to make or receive payments denominated in foreign currency.

~ Here, GM has a contractual payment obligation in Euro currency for a particular contract of buying engines from a European factory. Hence, it falls under the category of Transaction Exposure.

~ It cannot be translation exposure or operating exposure; because translation exposure is the effect of currency fluctuations on a company’s consolidated financial statements, particularly when it has foreign subsidiaries; and operating exposure is effect of unexpected currency fluctuations on a company’s future cash flows and market value and is long-term in nature, it is not related to a particular contract or a particular transaction, it is more general in nature for the whole company.

How can GM hedge this exposure to foreign exchange risk? Explain why the strategy works.

~ GM has a payment in Euro after two months.

~ The payment in two months = 2000 engies x EUR 2500 = EUR 5,000,000 = Eur 5 million.

~ Therefore, GM has a risk that Euro (the currency in which it has to pay) will appreciate in two months.

~ Therefore, to hedge this risk, GM should BUY (go LONG) the two month forward contract at the two-month forward rate $1.1 USD/EUR for Eur 5 million notional value.

~ This will ensure that GM will pay Eur 5 million at a fixed rate of $1.1 USD/EUR.

~ Now, if after two months, suppose the exchange rate is $1.35 USD/EUR, but GM has locked its payment rate at $1.1 USD/EUR. Therefore, GM's gain from the hedge is ($1.35 - $1.1) x 5 million  = $1.25 million.