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Liability management at GM
1. Liability Management at GM
Group 3
ANDRE, CHUN MUN WAI
AKHIL BHATNAGAR
GOH PENG YANG DAVY
Brian PARK BONGHEE
2. Story Line
In Feb. 1992, GM plans to raise U$400M through a public offering
Noncallable five-year note, with a fixed interest rate
of 7.625%, guided by policy on liability portfolio
management, the current structure of its liabilities,
and Mr. Bello’s best reading of trends in the bond
markets.
Engage in a wide range of derivative activities
including Interest-rate swaps, Caps, Treasury options
or Swap option(Swaptions), based on Mr. Bello’s
judgment of the future of interest rates and volatility,
the future shape of the yield curve, and the interest-
risk exposure
3. GM’s Financial Policy
To ensure the stability of corporate cash flows, to
facilitate and support new and existing product plans and
other strategic initiatives, and to create and return
shareholder value.
• GM’s financial policy consisted of a set of targets for key
financial management activities, including the management
of cash balances, leverage, liability structure, risk
management, and dividends
4. GM’s Liability Management Policies
Home Base – matching liabilities to assets
• To ensure that the general nature of the firm’s liabilities were
closely related to those of its earning assets, so that “any impact
on operating cash flow caused by movements in interest rates is
largely offset by changes in the value of the firm’s liability
portfolio.”
Active Management around home base
• By adjusting the composition of GM’s liability portfolio in step
with changes in rates over time, GM should be able to accomplish
a meaningful reduction in total debt service costs.
5. Rate View February 1992
Based on external and internal information, market is
uncertain and economy is transitional
Interest rates decline due to heavy supply of bonds sold by the
U.S. Treasury
Bond market rally over the next two months due to weak
economy during the first half of the year, high level of
uncertainty in the market
The yield curve flatten as the spread between long and short
rates converged
6. How changes in interest rates affect GM?
High Interest Rate
• Increase firm’s borrowing costs affects the profitability
• High auto loan, consumer buy less affects revenues
Volatile Interest Rate
• Changes in the cost of borrowing affect business
operations and decision as well as cash flow
Auto loan vs. • Negative relationship
• 1% increase in the interest rate would
Revenues result in a 7.94% drop in revenue
Auto loan rate versus revenue (Based on US Federal reserve archives)
y = -0.0794x + 12.338, R² = 0.7182
- Passed P-value Test, 71.8% could be explained by the formula.
The equation was statistically significant at 95% confidence interval.
8. Do Nothing (Issuance of $400m debt)
Principal ($) 400 Mn Other feature:
Fixed Coupon Rate 7.63% 1. No call provisions
Interest to be paid 0.50 (semi annually) 2. No sinking fund
Semi annual Payment
Amount ($) 15.25 Mn 3. No right to extend maturity
Maturity 5.00 years
No. of Payments 10.00
Bond Face Value ($) 100.00
Issued at Discount 99.98%
Notes sold for ($) 99.976
($ Mn) - 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Gross Proceeds 399.904
Less: underwriter
commission - 1.80
Less: expenses - 0.18
Interest payments - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25
Principal repayment -400.00
Net Cash Flow 397.93 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 -415.25
NPV of Cash Flows 397.93 - 14.68 - 14.13 - 13.61 - 13.10 - 12.61 - 12.14 - 11.69 - 11.25 - 10.83 -283.90
Yield Rate 7.902%
Bond
Issued Receive
Pay
Fixed Fixed Fixed Fixed Fixed
9. Do Nothing (Conclusion)
• Lock in a coupon rate of 7.63%
• Effective cost of capital increases (After underwriter fee and other
expenses) is 7.902%
• Insulate its cash flows fully from any interest rate exposure
• Not be able to lower its cost of debt should interest rates decline.
19. Swaps (Conclusion)
Current 6-month LIBOR rate: 4.31%
Probability of LIBOR rates below 4%: ~ 0%
Swap contracts - unsuitable for insulating GM’s
cash flows and lowering its cost of capital
20. Options on Treasury Notes
• Call option on 5-year treasury note
• Holder has the right to purchase $100 face value of treasury
notes at the end of 60 days at the strike price
• Seller receives a premium
5 year Treasury Note:
Strike Price ($) Face Value ($) Premium For Bull Spread Yield
98.095 100 0.625 Buy 6.66%
99.045 100 0.328 Sell 6.46%
21. Options on Treasury Notes
Create a bull spread using options on treasury notes
5 year Treasury Note:
Strike Price ($) Face Value ($) Premium For Bull Spread Yield
98.095 100 0.625 Buy 6.66%
99.045 100 0.328 Sell 6.46%
1.5000
1.0000
0.5000 Buy
Sell
- Profits
95.00 98.10 99.05 100.00
-0.5000
-1.0000
22. Options on Treasury Notes
BUT WHAT ABOUT MAKING MONEY FROM PREMIUMS???
As we expect future yield rate to be high, most probably we will operate below our bull
spread
Strike Price @ Feb '92, 3 Mo T Premium On Maturity Total Profit
Maturity rate (Rf)
Buy Sell ($) ($)
100.000 3.80%- 0.629 0.330 0.950 0.651
99.045 3.80%- 0.629 0.330 0.950 0.651
98.095 3.80%- 0.629 0.330 - - 0.299
95.000 3.80%- 0.629 0.330 - - 0.299
• If the price at maturity is above $98.40: reduce the cost of capital to a maximum of
7.88
• if the price is below $98.40: increase its cost of capital to a maximum of 7.92%.
23. Options on Treasury Notes (Conclusion)
•Long term yield curve would flatten (ie. Short term rates will
keep increasing)
•Current yield of 5-year Treasury notes was 6.65%.
•Long term yield rate to remain high above its current level -
supported by the banks’ forecast
•Need at least a yield of 6.66%
•Price at maturity would operate below the bull spread
•Not a suitable instrument to control GM’s interest rate
exposure.
24. Benchmark Caps
• Sell an interest-rate cap
Exercise
Type Maturity (yrs) Price Premium
Cap 5 9% 1.77% 2.13%
Cap 5 10% 1.06% 1.42%
• GM gets a premium which would reduce cost of borrowing
• GM obligated to pay any positive difference between LIBOR and rate
cap
• The cap with an exercise price of 9%:
• Premium - $8.52m; cost of capital - 7.37%
• Cap with an exercise price of 10%:
• Premium - $5.68m; cost of capital - 7.54%
25. Benchmark Caps
Case 1: Write a Call at 9% exercise price
LIBOR @ Exercise Feb '92, On
Maturity Price 3 Mo T Premium Maturity Total Profit
rate (Rf) Buy Sell ($) ($)
12% 9% 3.80% 8.531 - 12.000 - 3.47
10% 9% 3.80% 8.531 - 4.000 4.53
9% 9% 3.80% 8.531 - 8.53
7% 9% 3.80% 8.531 - 8.53
Case 2: Write a Call at 10% exercise price (65-70% of the time LIBOR is under 10%)
LIBOR @ Exercise Feb '92, On
Maturity Price 3 Mo T Premium Maturity Total Profit
rate (Rf) Buy Sell ($) ($)
12% 10% 3.80% 5.109 - 8.000 - 2.89
10% 10% 3.80% 5.109 - 5.11
9% 10% 3.80% 5.109 - 5.11
7% 10% 3.80% 5.109 - 5.11
26. Benchmark Caps (Conclusion)
•The probabilities of the caps not being exercised:
• 50% (for exercise price of 9%)
• 65% (for exercise price of 10%)
•Sellinga cap with exercise price of 10% would meet GM’s
objectives about 65% of the time.
•Downside risk of unlimited losses at interest rates above 10%
make it only a moderately attractive instrument
(esp. in the light of expected flattening of the yield curve
27. Swaptions
Exercise period Maturity of swap Fixed rate Premium (in basis
point)
2 years (2 by 5) 3 yrs 9% 89 – 108
3 years (3 by 5) 2 yrs 9% 94 – 111
• An option to enter into an interest-rate swap
Bond
Issued Receive
Pay
Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed Fixed
Fixed Fixed Fixed Fixed Fixed Fixed
Swap Receive
Pay
Floating Floating Floating Floating Floating Floating
29. Swaptions (2 by 5)
CASE 2: LIBOR rate at which GM will be indifferent
($ Mn) -
0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Net Cash Flow from - - - - - - - - - -
Bonds 397.93 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
Fixed Rate SWAP
payments received - - - - - 18.00 18.00 18.00 18.00 18.00 18.00
Premium on writing
the call 3.56
Indifference 6 Mo
LIBOR rate 4.70%
- - - - - -
Floating rate payed - - - - - 18.78 18.78 18.78 18.78 18.78 18.78
- - - - - - - - - -
Total 401.49 15.25 15.25 15.25 15.25 16.03 16.03 16.03 16.03 16.03 416.03
- - - - - - - - - -
NPV of Cash Flows 401.49 14.68 14.13 13.61 13.10 13.26 12.76 12.28 11.83 11.39 284.46
Sum of NPVs 0.00
Yield Rate 7.90%
30. Swaptions (3 by 5)
Years To Maturity
Corporate AA
Borrowers 1 2 3 4 5 7 10 20
Now 4.95% 5.75% 6.42% 6.98% 7.33% 7.67% 8.00% 8.45%
Forward years 1 6.55% 7.16% 7.66% 7.93% 7.98% 8.15% 8.36% 8.67%
Forward years 3 8.67% 8.70% 8.54% 8.52% 8.55% 8.68% 8.65% 8.91%
Annual Forward rate 8.46% 8.67%
6 months Forward
rate 4.23% 4.34%
LIBOR at discount to
AA 0.90% 0.90%
6 Months LIBOR
rate 3.33% 3.43%
CASE 1: On 6 Month LIBOR RATE
($ Mn) - 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Net Cash Flow from
Bonds 397.93 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 415.25
Fixed Rate SWAP
payments received - - - - - - - - - - -
Premium on writing
the call 3.76
Floating rate payed - - - - - - - - - - -
Total 401.69 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 15.25 - 415.25
NPV of Cash Flows 401.69 - 14.70 - 14.16 - 13.65 - 13.16 - 12.68 - 12.22 - 11.78 - 11.35 - 10.94 - 287.05
Sum of NPVs 0.00
Yield Rate 7.66%
31. Swaptions (3 by 5)
CASE 2: LIBOR rate at which GM will be
indifferent
($ Mn) -
0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00
Net Cash Flow - - - - - - - - - -
from Bonds 397.93 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 15.25 415.25
Fixed Rate
SWAP payments
received - - - - - - - 18.00 18.00 18.00 18.00
Premium on
writing the call 3.76
Indifference 6 Mo
LIBOR rate 4.82%
Floating rate - - - -
payed - - - - - - - 19.28 19.28 19.28 19.28
- - - - - - - - - -
Total 401.69 15.25 15.25 15.25 15.25 15.25 15.25 16.53 16.53 16.53 416.53
NPV of Cash - - - - - - - - - -
Flows 401.69 14.68 14.13 13.61 13.10 12.61 12.14 12.67 12.20 11.74 284.81
Sum of NPVs 0.00
Yield Rate 7.90%
32. Swaptions (Conclusion)
• 2-by-5 swaption: Premium - $3.56m; Cost of capital - 7.68%
• 3-by-5 swaptions: Premium - $3.76m; Cost of capital - 7.66%.
• The threshold 6-month LIBOR rates:
• 4.7% (for 2-by-5)
• 4.82% (for 3-by-5)
• Probabilities of making a loss: 40% - 45%
• Plausible instruments BUT
• Downside risk of unlimited losses at interest rates above
9.4%/9.64%
• Only moderately attractive instrument
33. Recommendation
• Core principle for risk management
-To reduce the variability of GM’s cash flows and lower its expected
costs of financial distress
• Timing the market to reduce their cost of capital
-Grey area between hedging and speculation
Recommendation:
•To issue the $400m note without any accompanying derivative
• Doing nothing meets the core objective of hedging (ie. insulating its
cash flow from interest rate risk).
• All other alternatives increase the variability of cash flows and serve
more towards the objective of lowering the cost of debt
• Explore the possibility of issuing a recallable note instead of a plain
vanilla one.
34. Suggested Improvement to GM’s programme
• Consolidation of the New York and Detroit Office to
reduce duplication of work and could better maximize
the resources.
• Clear guidelines for the various offices
• Treasurer’s office to set financial targets
• Liability management program should be less
speculative in nature.
• Counterparty exposure:
• By hedging large sums of debt involves exposure to
multiple parties thereby increasing the counterparty risk.
