Managing Financial Risk in a Multinational Context Published October 22, 2008 by: Jacon Wyans Researchers examining the

methods used by multinational corporations to mitigate their financial risks have noted that there are a plethora of methods that can be used to achieve this end. In particular, the following have been noted as widely used by General Motors as a means to reduce financial risk: selecting low cost production sites, using a flexible sourcing policy, diversifying the market, and financial hedging. While all of these methods can be used for the development of the organization in an international context, General Motors has clearly favored the use of the first two: selecting low cost production sites and using a flexible sourcing policy. Through the use of these methods, it has been possible for General Motors to enter a host of foreign markets and compete successfully with a number of different brands (Griffin, 2006). While the specific context of the market strategies used by the GM organization are important to understanding the overall success of the company, it is evident that the methods used by the organization to mitigate financial risk are of particular concern in this case. For this reason, it is pertinent to now consider the specific methods that the organization has developed to address the transaction exposure, operating exposure and translation exposure that can occur through undertaking foreign operations. By examining these issues in the context of the GM organization it will be possible to examine the use of financial theory in practice. Transaction Exposure Griffins (2006) in his examination of the specific methods used by General Motors and other large multinational corporations to mitigate transaction, or foreign exchange rate, exposure note that hedging is the most common method for mitigating this risk. Hagelin (2003) in his examination of the use of hedging to improve outcomes for multinational organizations notes that: "Transaction exposure to currency risk refers to potential changes in the values of future cash flows (committed or anticipated) as a result of unexpected changes in exchange rages. Hedging transaction exposure can increase firm value by reducing the variability of cash flows and thereby reducing expected costs associated with financial distress, taxes or the underinvestment problem" (p. 56). Thus, hedging can be a valuable tool for some organizations to effectively mitigate their financial risk as a result of changes in the foreign exchange rate. Other authors have also examined the use of hedging as an option to improve outcomes for the organization with respect to foreign exchange rate. According to Steil (1992) most organizations apply what has become known as the Giddy Rule when it comes to international business operations. Defining this rule, Steil notes that when it comes to the issue of foreign exchange rate in the context of international business, "In such cases what is needed is not the obligation but the right, to buy or sell a designated quantity of a foreign currency at a specified price. This is precisely what a foreign exchange option provides. ...When the quantity of a foreign currency cash flow is known, sell the currency forward; then when the quantity is unknown, buy a put option

on the currency" (p.414). By applying this simple rule, the organization can effectively ensure that it will get the best exchange rate available over a given time period. While hedging appears to be the best option for mitigating transaction exposure, researchers examining this process have noted that there are a plethora of hedging methods that can be used to ensure the financial success of the organization. Fong (1997) reports that there are a host of tradition tools that can be used for currency hedging. These include: currency forwards, currency options, currency futures, and currency swaps. Examining the benefits and drawbacks associated with these hedging options, Fong goes on to make the following observations: - Currency Forwards: "Forward contracts, being negotiable instruments traded in the over-the-counter (OTC) market, allow flexibility with respect to the size and maturity of the contract. The costs associated with forward contracts include the required heavy collateral or bank guarantees to ensure counterparty compliance with the contract terms at maturity; this requirement uses up bank credit lines" (p. 20). - Currency Options: "Currency options involve limited downside risk and, at the same time, retain the upside potential for profit. The costs are associated with the option premium, which, in turn, is related to the volatility and the interest rate associated with the underlying currency" (p. 20). - Currency Futures: Currency futures offer the benefits of easy access and the guarantee of an exchange rate. However, these futures can include high vulnerability to margin calls and high commissions. - Currency Swaps: "The benefits of swaps include easy access to complex exposures and the ability to customize a wide range of structures. The disadvantages of swaps include extensive documentation and potential counterparty risk associated with any transaction" (p. 20). At the present time, Leone (2005) reports that GM uses a combination of these methods in order to successfully mitigate foreign exchange exposure. However, Leone does note that in recent years, GM has made attempts to reduce the amount of hedging it undertakes. According to this author, when GM first entered the foreign market, it sought to hedge 100 percent of its foreign currency options. Today, the organization hedges about 50 percent of its foreign currency and works with only three foreign currencies: the dollar (short), the yen (long), and the pound sterling (long). Because hedging does not produce any real value for the organization and also includes considerable risk, GM has decided to reduce the amount of currency that it hedges overall. Operating Exposure Research on mitigating the impact of operating exposure demonstrates that this process carries with it a number of notable challenges. Kim and McElreath (2001) report that:

Prior research finds that this exposure depended on the characteristics of the industry, firm-specific operating activities, and the relative strength of the dollar vis-a-vis the relevant foreign currency. The valuation effects on a firm from corporate foreign investment decisions depend on accounting versus economic effects, and home versus foreign market effects. It has also been shown that the effects on firm value from foreign expansion or retraction is different by industry, by changes in exchange rates, and by the degree of foreign involvement before events (p. 21). These authors go on to note that unlike transaction exposure that impacts only one aspect of the organization, operating exposure impacts every dimension of the operations of the organization. For this reason, developing a salient method for mitigating operation exposure can be a challenging task for the organization. With the realization the mitigating operating exposure is such a difficult issue for the organization, Kim and McElreath provide a case study which aptly demonstrates the specific methods that are used in automobile industry to mitigate this type of risk. In order to elucidate the methods used to achieve this end, the practices identified by Kim and McElreath in the context of the automobile industry will first be considered. With these issues examined, it will then be possible to consider the particular methods used by General Motors to mitigate this type of exposure. Among the most notable methods used by automobile organizations to lower operation exposure is the selection of plant locations. In most cases, auto manufacturers will locate plants in countries that have historically low labor costs and stable political environments. "Ford Motor Co., General Motors and Honda have all established substantial production in Mexico, where labor is cheap and high quality. The automakers view Mexico as a vital export platform for sales of cars to rapidly growing Latin American markets" (p. 23). Further, GM has also established plants in Asia, the fastest growing car market in the world. The second method used by organizations to mitigate operation exposure is joint ventures. Joint ventures are often undertaken with companies located in the host country. These arrangements enable the multinational corporation to lower costs through cost sharing. Joint ventures also offer a host of other benefits including: allowing smaller companies to access larger markets, providing the organization with integral knowledge of the foreign country and linking technology to the organization. At the present time GM is aggressively pursing joint ventures with automobile companies in Asia. Productivity improvements have also been used as a means to reduce operation exposure. According to Kim and McElreath, many automobile manufacturers in an effort to improve their competitive edge in the global market have found that internal changes that improve productivity and output are critical toward reducing operation exposure. While it is evident that productivity improvements have a number of ramifications for the financial success of the organization overall, in the context of managing operation exposure, this process can be quite beneficial for the organization in this specific area. Currently, General Motors is seeking to reduce its time for vehicle completion by one-fifth. This would reduce production costs by one-fourth. Clearly this

represents a considerable savings for the organization that will reduce operation exposure. Finally, Kim and McElreath note that pricing strategy, product segmentation and incentive packages have all been used by automobile manufacturers in order to reduce operation exposure. As noted by these researchers, General Motors as well as other car manufacturers have found that in order to attract more consumers, the specific products developed and sold in foreign countries must be tailored to the needs of consumers in these countries. For instance, in the mid and late 1990s, auto manufactures found that they had to make cheaper cars for the Mexican market due to downturns in the local economy. If these changes had not been made, sales in Mexico would have plummeted. Kim and McElreath report that product diversification and incentive packages have also been utilized by General Motors in an effort to boost sales of cars in foreign markets. Translation Exposure Translation exposure refers to the problems that can arise for the organization when the financial statements from foreign operations are translated into currency values from the home country. Reviewing what has been written about the specific methods that can be used for mitigating translation exposure, it is evident that hedging can also be used in this area as well. With respect to the types of hedging that are available for managing translation exposure, it has further been noted that the temporal and current rate method can be used to achieve this end. At the present time, General Motors employs the temporal method to protect the organization against the risks associated with translation exposure (Klein, 2004) With the realization that the General Motors organization utilizes the temporal method for hedging translation exposure, it is helpful to consider the basic context of this method and the specific differences that exist between this method and the current rate method. Defining the temporal method of hedging, researchers observe that: Under the temporal rate method, the objective is to measure each subsidiary transaction as though the transaction had been made by the parent. Monetary items (e.g. cash, receivables, inventories carried at market, payables, and long-term debt) are re-measured using the current exchange rate. Other items (e.g. prepaid expenses, inventories carried at cost, fixed assets, and stock) are re-measured using historical exchange rates (Smith, 2005). This process differs from the current rate method in that under the current rate method, income statements are translated using the current exchange rate. In cases of owner's equity and dividends, translation occurs with respect to historical rates which reflect the "exchange rate at the time the asset was acquired, liability incurred, or element of paid-in capital was issued or reacquired (Smith, 2005). Although both methods are considered viable for reporting, the current rate method is more widely used by multination corporations. This may explain why General Motors has encountered some accounting problems as

of late. In 2005, the GM organization announced that it would have to restructure its financial statements for 2002 through 2004 to include some $2 billion in loses not previously recorded. This announcement comes at a time when consumer confidence in the organization has been shaken as a result of poor performance in the US market and an announcement of massive layoffs which are expected to take place over the next several years (GM shares..., 2006). Conclusion Critically reviewing what has been written about the methods used by General Motors to mitigate the financial risks of operating in a multinational context, it is evident that the organization has made some positive and negative choices. Overall the methods used by the organization to mitigate both transaction and operation exposure appear to be quite salient for meeting the needs of the organization. Recent efforts to reduce transaction exposure by reducing the number of foreign currencies encountered by the organization appears to be a positive step toward improving the financial stability of the organization. Even though methods for mitigating transaction and operation exposure appear to have had a positive impact on the organization, the company's decision to use temporal hedging methods does not appear to be having a positive impact on the organization. For any company seeking entrance into the foreign market, the lessons learned in the case of General Motors can clearly provide a basis for decision-making when developing foreign subsidiaries. References Fong, H.G. (1997). Currency risk management in emerging markets. Emerging Markets Quarterly, 1(3), 19-24. GM shares hit after '05 loses rises by $2 billion. MSNBC. Accessed April 3, 2006 at: http://www.msnbc.msn.com/id/11865286/. Griffin, J. (2006). Exchange rate exposure. Yale University. Accessed April 3, 2006 at: http://www.som.yale.edu/faculty/jmg93/intl/notes/L03%2015%20%20Exposure.pdf. Hagelin, N. (2003). Why firms hedge with currency derivatives: An examination of transaction and translation exposure. Applied Financial Economics, 13(1), 55-69. Kim, Y., & McElreath, R. (2001). Managing operating exposure: A case study of the automobile industry. Multinational Business Review, 9(1), 21-27. Klein, G. (2004). Which accounting method is really appropriate? UCLA Anderson School of Management. Accessed April 3, 2006 at: http://www.anderson.ucla.edu/course/20042005/fa12401/download/CHAP011.DOC. Leone, M. (2005). Gaining currency? CFO Magazine. Accessed April 3, 2006 at: http://www.cfo.com/article.cfm/3804665. Smith, L.M. (2005). Foreign currency translation. Mays Business School. Accessed April 3, 2006 at: http://acct.tamu.edu/smith/fctrans.htm. Steil, B. (1993). Currency options and the optimal hedging of contingent foreign exchange exposure. Economica, 60(240). 413-431.