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.

Answer 1

Let us discuss about the three types of exposures that an entity faces when it is doing a forex operation.

Translation Exposure - This is the accounting-based exposure that occurs when we are consolidating the subsidiaries financing statements which is in a foreign country with the parent's financial statements as per the relevant accounting standards and statue

Operating Exposure - Change in the cash flows arising due to sudden change in the foreign exchange rate which is not with in the control of the entity.

Transaction Exposure - This measures the change in exchange rate due to obligations that have already occurred before the rates have changed but the settlement of which occurs after the exchange rate has changed .

Here we can say that General Motors have an transaction exposure because the obligation to pay EURO has arisen today because of purchase of goods and the same has to be settled in 2 months.

Hedging Strategy -

The most widely accepted hedging strategy for foreign currency recievable and payable which occurs due to change in the exchange rate that is due to transaction exposure is through forward contract with a forex dealer.

These are generally banks and financial institutions . Generally banks and financial institutions enter into an agreement with the customers to give or receive a fixed amount of foreign currency in future. When a importer or exporter enters into a forward contract he is least bothered about change in exchange rate.

Simliarly he can also enter into derivative contracts like call options, put options , futures etc

Here we can say that a call option on euro will better hegde the foreign curency payable. In simple terms the importer is afraid of foreign currency appreciating. That means he has to do somethhing that will benefit him from foreign currency appreciation. Hence as a call option is right to buy at a particluar price any raise in the exchange rate will benefit him.

Hence we can say that this benefit form call option and loss from put option can be nullified and it can be hedged .