General Motors Corporation, the world’s largest automaker, has an extensive global outreach, which places the firm in competition with automakers worldwide, and subjects itself to significant exchange rate exposure. In particular, despite most of its revenues and production being derived from North America, depreciating yen rates pose problems for the firm indirectly through economic exposure. While GM possesses ‘passive’ hedging strategies for balance sheet and income statement exposures, management has not yet quantified or recognized solutions to possible losses from the indirect competitive exposure it now shared with Japanese automakers in the U.S import market. As the yen depreciates against the dollar, Japanese automakers production cost structure reduces; this allows for lower sticker prices, added per-vehicle incentives, and the ability for Japanese firms to eat away at GM’s current revenue-generation from the United States. By using a projected 20% devaluation of the yen, and given unit sales figures and industry elasticity, the competitive exposure of GM to the real JPY-USD spot exchange rate is roughly $1.6b.
This base case is established as the most likely scenario, yet sensitivity analysis of varying percentages of JPY content per-vehicle and cost-savings distribution to consumers showcase a much wider range of potential exposure values. When summing this competitive exposure with the remaining exposures (commercial, affiliate, and borrowing), I find that GM has an overall $1.2b exposure to the yen globally. Further, I suggest an alternate, less information-intensive means for calculating a similar figure, which includes regression of GM returns to market returns, then finding an exposure coefficient to JPY-USD fluctuations; this helps to show how returns of the firm are correlated specifically to their yen exposure. While direct calculations are not performed, this method would provide a good check for the first calculation, by using historical figures. Finally, I conclude that the best way to hedge away this significant exposure is through operational hedging methods, as they present a longer-term solution.
The yen has consistently been a highly volatile currency, and as long as it remains floating, this trend will continue. Thus, short-term financial hedge opportunities like forwards, swaps and options are insufficient, and do not respond well to immediate directional changes in the XR. Thus, General Motors should look into more permanent means such as looking for a low-cost production center, or utilizing alternative sourcing options; this will allow for lower costs, allowing GM to respond to Japanese sticker price cuts, with their own, while also maintaining both market share and profit margins. As these alternatives are operational they succeed in hedging roughly 100% of exposure, and therefore significantly alter GM’s overall currency exposure portfolio in a very positive way.
Since 1931, General Motors Corporation has successfully maintained its place as the world’s largest automaker with 8.5 million vehicles sold in 2001 in 200 countries worldwide. However, its global presence has substantially increased the firm’s foreign currency exposure. In particular, despite North America representing the majority of revenues (72%), and geographic location of net PPE (75%), the real yen-dollar exchange rate has provided a significant degree of economic and competitive exposure for GM’s finances and operations. In regards to transaction exposures, GM senior executives have placed formal policies to mitigate the earnings and CF volatility from deviations in FX rates; however, the current ‘passive’ strategies pay no attention to possible losses due to the indirect competitive exposure it now shared with Japanese automakers in the U.S import market. The Impact of Yen Depreciation
General Motors is concerned with the yen’s devaluation because Japanese automakers’ costs are based in yen, yet their sales pricing is based in U.S. dollars. Having appreciating USD in their assets column, with depreciating yen in their liabilities column, this has lowered cost structure and expanded profit margins for firms such as Nissan, Honda and Toyota. Now, these automakers are able to pass on their reduced costs to consumers via sticker price reductions between 15-45% of cost savings, or through added incentives. According to Exhibit 6, as of 2000, per-vehicle incentives of GM ($1,969) far exceeds those of Toyota and Honda, at $725 and 664, respectively; this competitive advantage GM currently holds, as well as its relative market share in the U.S., are endangered if Japanese firms choose to move their incentive values closer to the industry average.
Looking into the competitive threat more closely, the auto industry in the United States is rather sensitive to price, with a price elasticity of 2, or a 5% increase in price contributing to a subsequent 10% fall in demand. Thus, based upon the sticker price decreases potentially implemented by Japanese automakers, Japanese companies’ combined market share (roughly 4.1m units in 2000) stands to increase substantially, and could eat into General Motors’ overall market share. To highlight the sensitivity to the USD-JPY spot exchange rate, GM’s VP of Finance, Eric Feldstein, suggests that just a one-yen depreciation increases competitors’ operating profit by $400m. With $900m in net yen receivables, $500m in outstanding yen-denominated bonds, and more exposure via equity stakes in Japanese firms, through its investment and competition’s response, GM stands to lose a significant amount of money due to its yen exposure. Why is this Yen Exposure Important?
General Motors’ investment- and competitive-based exposure to the JPY is an important problem because of the potential changes necessary to respond to possible market share and demand fluctuations. With 72% of overall revenue generated in the U.S., GM has very significant reason to be concerned with their domestic demand. Collectively, Japanese automakers derived 43% of their revenues from the U.S. import market, meaning they have a strong foothold already, and reduced costs and increased incentives stand to be very beneficial to their current demand. Operationally, General Motors must be able to respond to this changing competitive environment. This could either mean inventory management to comply with changing demand, pricing strategy alterations, sourcings, relocations, or a number of other options to minimize the damaging impact of the yen’s depreciation. Thus, it is important for GM to recognize the quantitative impact in the near-future, so that it can efficiently hedge to an appropriate degree without investing too intensively.
Other important considerations in determining their course of action are the significant volatility of the USD-JPY exchange rate over time. Upon looking at the figures in Exhibit 4, over the 10-year span from December ‘89 to December ’99, the JPY/USD spot rate appreciated 25.8% from 144.9 yen/$ to 107.59 yen/$. Annual percentage changes are shown in Appendix A. Within this 10-year time period, the spot rate experienced an 11.4% appreciation in ’93, and 11.9% and 13.8% depreciations in ’96 and ’97. In this span, the ‘trough’ of yen value was at 158.3 yen/$ in April 1990, and the ‘peak’ at 83.83 yen/$ in April 1995. Hence, there are often huge fluctuations in XRs, which have severe implications for GM and the Japanese automakers, who have operating profits highly tied to small fluctuations. On top of this, the net equity exposure GM has in Fuji, Isuzu, and Suzuki are short, but the companies are projected to grow in profitability past a 120 yen/$ spot rate, and Exhibit 4 shows a realistic December ’01 spot of 1.32. Therefore, since the rate is so volatile, GM must ensure their hedging strategy adequately prepares for dramatic directional shifting in the future. Calculating Value Exposure
By analyzing information in the case, it is possible to determine a holistic view of the total JPY exposure experienced by General Motors. The process followed is illustrated in Appendix B. First, it is necessary to recognize the potential price reduction in Japanese vehicles via a base case; this is established through assuming a 20% devaluation in the JPY/USD spot rate (as stated in the case), and using the mean JPY production content and passed-on cost savings (30% each). Once a value of 1.8% sticker price reduction was reached, this was factored into the provided sales price elasticity figure of 2.0, to find a 3.6% potential increase in demand. Taking into account the 2000 fiscal year numbers of 4.1 million Japanese-produced units sold in the U.S., this suggests 147,600 more sales units demanded. The next step is to determine the subsequent loss in sales units experienced by GM; Feldstein suggested that an offsetting position in sales would be divided between the Big Three: Ford, Chrysler, and General Motors. Thus, with a cross-price elasticity of .33, GM’s potential sales loss under the base case would be 49,200 units. Finally, to find the market value loss, this unit total must be multiplied by GM’s contribution margin to determine the total pre-tax loss, and then discount this by a 20% perpetuity factor.
Appendix B explains how the contribution margin factor was reached. Thus, for the base case, the present value of competitive exposure of General Motors would be ~$1.6b. After establishing the base case value, it is essential to conduct sensitivity analyses, as illustrated in Appendix C. Since the case provided ranges for two particular variables, these are the basis for our analysis. First, GM’s business development team posed the range of 20-40% for average JPY-driven content within Japanese automakers’ vehicles; second, GM’s sales and marketing teams indicated that the cost savings passed onto the U.S. consumer due to yen-devaluation-led cost reductions would be anywhere from 15-45%. Hence, these two metrics and the appropriate suggested ranges were the basis for the sensitivity analysis. Resulting competitive exposure estimates vary widely from $538m to $3.23b.
Upon establishing this competitive exposure figure, one must now look at the total exposure relating to commercial, affiliate investment, and borrowing exposures. The calculations in finding the final figure of $1,197m final exposure can be seen in Appendix D, and assume the previous base case calculations. As indicated in the case, GM expects net receivables of $900m, and it currently possesses a -$500 exposure from its outstanding yen-denominated bonds and an additional -$818m exposure from short positions in the Japanese firms Fuji, Isuzu, and Suzuki. Alternative Exposure Estimation Methods
If one possesses less company-specific information, it may be possible to extrapolate historical data for the purpose of projecting this forward into the future. One way to do this is by first looking at the stock’s beta to overall market calculation, which regresses GM returns to S&P500 returns. It is possible to regress a firm’s cash flow exposure to price fluctuations by adopting the firm’s beta calculation, then adding the product of an exposure coefficient and the change in the real JPY-USD foreign exchange rate. To fully isolate the single JPY-USD exchange rate effect, by setting up the regression this way, one is able to dismiss other exposures possessed by GM such as CAD-USD. This resultant exposure coefficient is a percentage exposure variable that can be multiplied to the firm’s equity value, to find the total value at risk as long as the JPY-USD rate remains unfixed.
The success of this estimation method relies on the assumption that past trends in beta exposure hold true into the future. It may be less specific and less weighed-down by details but it is accurate in isolating equity returns to exchange rate exposure, assuming a continuation in financial exposure, or that an increase or decrease in exposure results in a traceable change in GM equity return. This method is helpful because it allows one to quickly look at many firms across the industry by simply knowing the firm’s returns, and does not require the elasticities, revenue breakdown, and many other factors of the former method. Value at Risk, and Hedging
Appendix E looks at the current commercial exposures of General Motors in currencies globally, and showing the distribution model of a 50% hedged and unhedged portfolio. As can clearly be seen, hedging commercial exposure in line with the firm’s current ‘passive’ hedge strategy, significantly reduces value at risk by half overall, and the 6 month distribution of returns lowers substantially. In the next case, Appendix F, I look at JPY-USD competitive exposure as calculated at $1.615b. As will be explained in the conclusion, the strategies that best respond to the long-term nature of competitive exposure, attempt to hedge all the risk associated with the yen. Since the use of operational hedging cannot be guaranteed to hedge all volatility, I selected 99% hedging percentage for this case. Appendix F.A shows competitive exposure along with the rest of the initial 50% hedged commercial currency exposures, and F.B shows the yen by itself, as well as supporting graphs. The conclusion that may be drawn is that, just as the overall distribution decreases by a visible degree in the overall portfolio, by itself, essentially all potential JPY FX gains or losses disappear. Conclusion
In sum, while it easier for GM to quantify translational and transactional exposure, it is more difficult to find the indirect economic exposure that affects GM due to fluctuating spot rates, and the responsive global competitive landscape. Balance sheet and income statement effects are more short-run concerns, and are more simply hedged via the use of derivative products such as swaps, forwards and options. Competitive exposure is long-term and centers on operational effects, which must be treated differently. In tackling their roughly $1.6b exposure, GM must look into solutions that alleviate currency exchange issues, however the firm must be careful. Setting up low-cost production sites or using more flexible sourcing options prepare GM to lower costs, and subsequently prices, in line with Japanese competitors, so that its margins and market share are not drastically affected by JPY-USD fluctuations. These are good options in that they prepare GM for competitive yen (and other competitive countries’ currency) for the long term, yet GM must be mindful of brand perception, and these are very large one-time costs. While financial hedging opportunities exist, they all represent high potential costs, do not respond well to immediate volatility and XR reversals (as is common of the yen), and only offer a short-term fix. Thus, to combat its current issues with competitive exposure, GM should look to fully hedging through operational means.