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Chapter 17: Risk Management and the
Foreign Currency Hedging Decision
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
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Chapter 17: Risk Management and the
Foreign Currency Hedging Decision
17.1
To Hedge or Not To Hedge
17.2
Arguments Against Hedging
17.3
Arguments for Hedging
17.4
Merck’s Hedging Rationale
17.5
Hedging Trends
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17.1 To Hedge or Not To Hedge
To Hedge of Not To Hedge: Overview
• Introduction
• Hedging in an Entrepreneurial Venture
• Hedging in a Modern Corporation
• The Hedging-is-Irrelevant Logic of Modigliani and
Miller
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17.1 To Hedge or Not To Hedge
• Introduction
• Hedging = risk mitigation
• Risk management
• Derivative securities
• Used to take positions that offset the
underlying sources of risk
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17.1 To Hedge or Not To Hedge
• Hedging in an Entrepreneurial Venture
• Makes sense for entrepreneurs because
• Firm is unable to diversify risks as most
investors can
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17.1 To Hedge or Not To Hedge
• The Hedging-is-Irrelevant Logic of Modigliani and
Miller
• Modigliani-Miller proposition:
Key Idea: What changes investors’ perception of
the firm’s systematic risk?
• If hedging only changes non-systematic risk
while leaving systematic risk and expected value
of the cash flows unchanged,
• Hedging will not affect firm’s value
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17.2 Arguments Against Hedging
Arguments Against Hedging: Overview
• Hedging is Costly
• Hedging Equity Risk is Difficult, if not Impossible
• Hedging Can Create Bad Incentives
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17.2 Arguments Against Hedging
• Hedging is Costly
• A true hedging cost: The Bid-ask spread
• Typically larger in forward market
• Costs increase as contracts move further into
the future since spread widens
• The employee cost
• Trained staff necessary to monitor market for
hedging instruments
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17.2Arguments Against Hedging
• Hedging equity risk is difficult, if not impossible
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The Weehawken Widget Project
Changes in the project’s value over time
The project’s value with 1 year of hedged cash flow
The project’s value with 2 years of hedged cash flows
The project’s value with an infinite sequence of
hedged cash flows
– The project’s value with an equity hedge
– Reality is more complicated
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Exhibit 17.1
The Value of Weehawken’s Project with Unhedged
Cash Flows
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Exhibit 17.2
The Value of Weehawken’s Project with 1-Year
Hedged Cash Flows
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Exhibit 17.3
The Value of Weehawken’s Project with 2-Year
Hedged Cash Flows
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Exhibit 17.4
The Value of Weehawken’s Project with Infinitely
Hedged Cash Flows
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17.2 Arguments Against Hedging
Hedging Can Create Bad Incentives
• Firms near financial distress may be motivated for
the higher return that accompanies an unhedged
currency position
• They may attempt to profit in currency speculation
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17.3 Arguments for Hedging
Arguments for Hedging: Overview
• Hedging Can Reduce the Firm’s Expected Taxes
• Costs of Financial Distress
• Hedging Can Improve the Firm’s Future Investment
Decisions
• Hedging Can Change the Assessment of a Firm’s
Managers
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17.3 Arguments for Hedging
• Hedging Can Reduce the Firm’s Expected Taxes
• Tax-loss carry forward
• Convex tax code
• General principles: Tax benefits are larger when
• Tax code is more convex
• Firm’s pretax income is more volatile
• Firm’s income occurs in convex region of the
tax code
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Exhibit 17.5
A Convex Income Tax
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17.3 Arguments for Hedging
• Hedging Can Lower the Costs of Financial Distress
• By reducing probability a firm will encounter
distress
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17.3 Arguments for Hedging
Hedging Can Improve the Firm’s Future Investment
Decisions
• The basic logic of the argument
• If the firm hedges, it avoids shortfall in
internally generated cash and drop in
investment
• Asymmetric information is the problem
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17.3 Arguments for Hedging
• Hedging Can Change the Assessment of a Firm’s
Managers
• Hedging increases the informational content of a
firm’s profits about managers’ ability
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17.4 Merck’s Hedging Rationale
Merck’s Hedging Rationale: Overview
• Developing Natural Operating Hedges
• Merck’s Five Step Procedure
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17.4 Merck’s Hedging Rationale
• Developing Natural Operating Hedges
• Operating currency hedge
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17.4 Merck’s Hedging Rationale
• Merck’s Five Step Procedure
1. Develop forecasts to determine probability of
adverse exchange rate movements
2. Assess the impact of exchange rate changes on
firm’s 5 year strategic plan
3. Decide whether to hedge currency exposure
4. Select appropriate hedging instrument
5. Simulate alternative hedging programs to select
most cost effective
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17.5 Hedging Trends
Hedging Trends: Overview
• Information From Surveys
• Empirical Analysis of Why Firms Hedge
• To Hedge or Not to Hedge: Understanding Your
Competitors
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17.5 Hedging Trends
• Information From Surveys
• The Wharton/CIBC Survey
• 83% of large firms hedge
• 12% of smaller firms hedge
• Hedging contains fixed costs smaller firms
may not want to bear
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17.5 Hedging Trends
• Empirical Analysis of Why Firms Hedge
• To Hedge or Not to Hedge: Understanding Your
Competitors
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