Free Custom «Hedging Techniques at General Electric» Essay Sample
Hedging Activities at General Electric
1. Initial Hedging Techniques Used by General Electric
The present capital of General Electric (GE) is much stronger compared to 2008 due to the decision of the company to reduce its balance sheet and its effort to increase its level of cash, liquid instruments and other factors that enable it achieve liquidity while investments have been done to improve risk management capabilities (Abbink, 2010). Initially, it has been observed that GE used wrong hedging techniques through improper treatment of commercial paper (CP) issuances, which resulted into smoother reported earnings. It was also learned that, as a result of continued application of the present hedging techniques for its CP, there would be the need for accountability for fluctuations of values of CP interest rates swaps. Instead of making a report of these fluctuations, the company changed the hedge process it applied in a manner that it knew because it was clear there was no compliance with accounting rules.
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In most cases, GE issued CP. This refers to unsecured commitment to pay the purchaser a particular amount at an agreed rate of interest on maturity date. There is a cash payment by the purchaser to the issuer on the date of issue (Chong, 2004). The proceeds from these issuances were used by GE to fund a number of its financial activities, loans and leases. The process of addressing volatility has been facilitated through permission of special ‘hedge accounting’ for particular hedge relationships based on particular guidelines. For instance, cash flow hedge accounting has been used to enable an issuer to keep specific changes in the value of its derivatives from being indicated in the revenues. This form of hedging also enables issuers to keep specific changes in the right value of its derivatives and the value of the base hedged risk (DeFalco, 2013).
2. Current Techniques of Hedging Used by GE
Derivatives are currently used for risk assessment and for task speculations. The objective in risk management has been mitigation of risk and change. Interests and other payments are calculated on the basis of national amounts and are the reported gross, with theexception when foreign currencies are being offset for execution in order to manage the investments risks of the company in its subsidiaries (Eydeland, 2002). A greater part of national amounts is used for reducing interest rates, currency or market risk between a number of national liabilities and financial assets. When the instruments used in these activities can be predicted, they are referred to as hedges. When it is difficult to apply hedge strategies, or when there is a concurrent recording of hedged item and derivative, the derivative is assumed to be economic hedges, and this leads to elimination of the use of economic hedges (Greiner, 2013). This is mainly applied when a foreign transaction is hedged. Since there is a reflection of effects of both exchange rates in earnings for either derivatives or transactions, there is no need to apply an economic hedge during accounting. Majority of third party hedging at GE is carried out through a subsidiary.
2.1. Production Methods of Managing Operation Exposure
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There are cases, where the company has a large exchange rates margin, which makes marketing strategies and pricing difficult, resulting into the need to either drop the products or reduce costs (Kim, 2011). In order to manage competitive risks, products or principle production strategies that cannot be handled by marketing strategies alone, product mix, product sourcing and plant location are strategies used by GE.
For instance, GE has been diversifying into activities that result into offsetting its exposure to exchange rates. This has been achieved by combining production and selling of its manufactured goods through importing activity, where a competitive product is imported from foreign producers (Madura, 2012). As a result, a natural hedge is created, which ensures that the total value of cash flow is steady with respect to real exchange rates’ movements. Despite a great amount of value for this strategy, it has a number of limitations: it can result into venturing into inefficient source of resources, or there is a possibility of considering the two activities as one and enable cross-subsidization to take place for a greater period of time with little consideration for economic viability of each activity as a single activity.
Another production method for hedging used by GE is diversification of sources of input. This is mainly applied when the company wishes to maintain its knitting so that operating costs can be reduced. In order to do this in a flexible way with respect to real home currency appreciation, the components are bought from overseas (Madura, 2013). When the input prices are not integrated with the global markets, the appreciation process involves lowering the dollar cost of inputs, consequently lowering the total costs of production. In other cases, the company may opt to apply the option of designing new regional facilities, which result into increased flexibility in making substitutions among a number of input sources by forming domestic or international sources (Syz, 2008). The disadvantage of this strategy is that it does not bode effective for the concept of good supplier relations, and there is a high possibility of switching supplier demands during application of this strategy.
2.2. Resolution Planning and Corporate Governance Structure
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The importance of resolution planning is recognized by GE as the major factor during risk management, not just during crisis but also during business activities. The main components of GE’s risk management system, such as policies and supporting procedures, are the component of its own resolution system (Chong, 2004). The risk management system for the company involves establishment of validity of the organization’s Risk Appetite Statement by the GE risk Committee. This is followed by codifying the Risk Appetite Statement by use of a management framework based on a defined governance structure, processes, limits, mitigation, and monitoring. The organization’s Risk Appetite Statement provides an articulation of the risk extent likely to be accepted by the company with respect to its business strategy and risk management structure of the company.
Based on the significant scope of planning stage, the Capital Department of the company has established an efficient structure to accomplish approval and maintaining plan of resolution, which is incorporated into the overall risk management system (DeFalco, 2013). The Resolution Plan is managed through the Sponsorship of Chief Risk Officer (CRO) of the company.
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