Gm Case: Stephanie Bellano Decision

Therefore, from the total firm perspective, we want to earn money when interest go up because that’s when GM needs cash the most as revenues are decreasing. We want to buy a derivative that makes money when interest rates go up in order to smooth earnings

Conclusion

The ultimate conclusion for Stephane should be to do nothing. The core principal of risk management for GM and in principal, the view of the board of directors is to reduce the variability of GM’s cash flows and lower its expected cost of financial distress. The three derivative options (vanilla swap, selling the cap, and treasury option bull spread) presented for Stephane to choose from in this case all correlate the same with interest rates as GM’s revenues. Therefore, the cost of capital will decrease when revenues are increasing. This is not the ideal time that GM needs the cash. Further, these derivatives increase the cost of capital (lose money) when interest rates increase and revenues therefore, decrease. This will cause the cash flow to decrease even more significantly than if Stephane would not have “hedged” at all and just held the fixed rate bond. In other words, the derivative hedge options presented seem monetize for GM a view on the market.

Ideally, GM would want to purchase a derivative product that hedged if interest rates increased. A hedge against interest rates increasing is necessary due to operating revenues negative correlation to interest rates. A type of derivative product that GM could buy to do this would be a cap with a strike interest rate of 5% (LIBOR is currently 4.31% in 1992). If interest rates were to increase above 5%, the cap be in the money and the cost of capital would decrease as GM would receive the positive difference between LIBOR and the cap. If interest rates did not increase above 5%, GM would lose the premium paid for the cap. An analysis would need to be run to determine the payoff diagram of