Financial weapons of mass destruction

PART 1: (40 marks)

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Berkshire Hathaway Inc. Chairman of the Board Warren Buffet, “Letter to the Shareholders of
Berkshire Hathaway Inc.,” February 21, 2003

Since the early 1990’s, there have been a number of high-profile businesses that have realised huge losses associated with the use of derivatives for hedging that went wrong. Better known cases in the 1990’s involved Barings Bank (195), Long Term Capital Management (1998), Procter and Gamble (1994), Metallgesellschaft AG (1993), and Orange County California (1993) whilst more recent cases include JP Morgan (2012), AIG (2008) and China Aviation Oil (2004).

You are required to choose ONE of the above companies. In relation to your chosen company, research into their derivatives failure, and answer the following questions:

(i) Describe the facts, including background (nature of company business, trading history, size, etc.) and nature and amount of losses realised;
(ii) Explain the risk that the company was subject to and detail Risk Management (RM) techniques that were used. Please note any specific derivatives hedging strategy.
(iii) Explain what went wrong in detail;
(iv) Evaluate the RM performance; and detail any lessons learned from the experience.

PART 2: (60 marks)

Choose ONE of the following two cases and answer the questions relating to your case of choice. Case readings are available from Moodle. You are encouraged to conduct your own extra research to answer the questions.

CASE 1: HEDGING AT PORSCHE
Porsche, a German manufacturer of performance cars, was known for a cautious approach to risk management and conservative financial policies. In 2007, however, it stunned analysts and investors by reporting billions of dollars of profits from transactions on financial derivatives. Some of these profits came from foreign exchange hedging, but much of them were due from a huge position in options on Volkswagen stocks. Volkswagen, one of the world’s largest car manufacturers and a company many times the size of Porsche, was partnering with Porsche on a number of development and manufacturing projects.
Porsche used the option to build an ownership stake in Volkswagen. Porsche argued that the ownership stake was necessary to prevent a hostile takeover and breakup of its key partner by a third party. Porsche’s executives further maintained that the options strategy to build the stake was prudent because it protected Porsche against the risk of a substantial rise in Volkswagen’s stock price once Porsche’s intentions became clear to market participants. However, critics argued that Porsche’s derivatives transactions represented reckless speculation that could put the entire company at risk.

Answer the following questions relating to the case.
(i) Should Porsche hedge its foreign exchange exposure? How do Porsche competitors, such as BMW, deal with this risk? Can Porsche do something similar?

(ii) Research Porsche’s option hedging strategy and describe it in detail. What would be an alternative hedging strategy? Which strategy is better for Porsche? (iii)How did Porsche build its Volkswagen stake? Why not buy Volkswagen stocks
directly?
(iv)Was Porsche’s attempt to build a stake in Volkswagen a sensible one? Or do you agree with critics who argued that Porsche was speculating with shareholders’ money and it had become a hedge fund that neglected its core business? Justify your answer.

CASE 2: FOREIGN EXCHANGE HEDGING AT GENERAL MOTORS
The Treasury team at General Motors (GM) is responsible for managing the corporation’s varied financial transactions and their associated risks. With operations and subsidiaries all over the world, GM has exposure to numerous currencies. The company’s hedging policy defines what exposures should be hedged and how the prescribed hedges should be implemented. GM’s passive hedging strategy is intended to minimize management time and discretion spent on hedging decisions and does not usually accommodate hedging translational exposures. Exceptions to the hedging policy must be approved by the Head of Treasury. The Head of Treasury is currently reviewing two proposals for the Canadian dollar and the Argentinean peso. He and his team have to evaluate GM’s exposure to each currency, determine the risks, consider other approaches to managing these currency risks, and decide if GM should depart from its formal hedging policy. If they decide to go ahead, they would also need to consider what instruments to use to implement the hedges.
Answer the following questions relating to the case.
(i) Should multinational firms hedge foreign exchange rate risk? If not, what are the consequences? If so, how should they decide which exposures to hedge?
(ii) What do you think of GM’s foreign exchange hedging policies? Would you advise any changes?
(iii) Should GM deviate from its policy in hedging its CAD exposure? Why or why not?
(iv) If GM does deviate from its formal policy for its CAD exposure, how should GM think about whether to use forwards or options for hedging?
(v) Why is GM worried about the ARS exposure? What operational decisions could it have made or now make to manage this exposure?

Sample Solution

ACED ESSAYS