International Finance

The Risk Management Decision: Why Hedge?

Main issues

• Should a multinational firm hedge exchange rate exposure?

• The Modigliani-Miller irrelevance benchmark

• When does hedging increase firm value?

• The Slite case: what happens when you don’t hedge

• Empirical evidence on corporate hedging

From Macro to Firm Decisions

The three decisions

The course now moves from macroeconomic context to the firm’s perspective.

The firm faces three interconnected decisions:

1. The hedging / risk management decision \(\leftarrow\) this lecture

2. The financing decision

3. The capital budgeting (investment) decision

We’ve spent Lectures 1-5 on the macro foundation: PPP fails (real FX risk exists), CIP holds (forwards are priced by arbitrage), UIP fails (risk premia exist), and exchange rates are essentially unpredictable. Now we ask: given all this, what should the firm DO?

Recall: what we know

• Nominal exchange rates are volatile.

• Changes in nominal exchange rates are not offset by changes in relative prices (PPP fails).

• Hence, changes in the nominal exchange rate have real effects.

• It is difficult to forecast future exchange rates (UIP/UEH fail).

• Exchange rate risk premia exist — hedging is not “free.”

The firm cannot forecast its way out of exposure. Should it hedge?

The Hedging Puzzle

Is the answer not obvious?

• Nominal and real exchange rates are volatile and difficult to predict.

• If firms do not hedge, their future revenues and costs are more volatile and more difficult to predict.

• Hence, designing hedging strategies that reduce the uncertainty of future revenues and costs should increase value…

…or shouldn’t it?

Example: hedged vs. unhedged

Setup:

• You will receive EUR 500,000 in one year
• \(r^{EUR} = 10\%\), \(r^{USD} = 5\%\)
• Spot rate: \(S_0 = 1.10\) (USD/EUR)

Unhedged value today:

\[V_0^{UH} = \frac{\text{EUR } 500{,}000}{1 + 10\%} \times \frac{\text{USD}}{\text{EUR}} \; 1.10 = \text{USD } 500{,}000\]

We discount the EUR cash flow at the EUR rate (10%) and convert at the current spot rate. This gives us USD 500,000 today. The key question: does hedging change this value?

Example: does hedging change the value?

Forward rate (from CIP):

\[F_{0,1} = S_0 \times \frac{1 + r^{USD}}{1 + r^{EUR}} = 1.10 \times \frac{1.05}{1.10} = 1.05\]

Hedged value today:

\[V_0^{H} = \text{EUR } 500{,}000 \times \frac{\text{USD}}{\text{EUR}} \; 1.05 \times \frac{1}{1 + 5\%} = \text{USD } 500{,}000\]

Hedging does not change the value!

This is not a coincidence — it is CIP at work. The forward rate adjusts so that hedged and unhedged positions have the same present value.

The M&M Benchmark

Modigliani and Miller

The M&M Irrelevance Theorem

The value of the firm is independent of its hedging policy when:

1. There are no taxes

2. There are no transaction costs in financial markets

3. Shareholders and firms have the same information

4. Shareholders and firms have equal access to financial markets

5. There are no costs of financial distress

Under these conditions, hedging cannot add value.

This is the benchmark. The MM result doesn’t say hedging is bad — it says hedging is IRRELEVANT under idealized conditions. The value comes from understanding which conditions fail in practice, because that’s where hedging creates value.

The M&M logic

• Hedging is a purely financial decision.

• Corporate managers cannot increase the value of the firm by undertaking financial transactions that shareholders can make themselves.

• If a firm decides not to hedge an exposure that shareholders dislike, shareholders can hedge it personally (“home-made hedging”).

This shifts the hedging from the corporate level to the personal level, at no cost.

Same logic as capital structure irrelevance: financial policy doesn’t matter in frictionless markets.

The diagnostic

\[\text{Value of firm} = \frac{E[\text{Cash Flows}]}{\text{Required Return}}\]

For hedging to increase firm value, it must:

• Increase expected cash flows, and/or

• Decrease the required return (discount rate)

Under MM, hedging does neither. The question becomes: which real-world frictions cause hedging to affect CFs or DR?

How Hedging Creates Value

Violation channels

Hedging can increase firm value because:

1. Costs of financial distress — hedging reduces the probability and expected cost of distress

2. Tax convexity — hedging reduces expected tax liability when the tax function is convex

3. Agency costs — hedging reduces conflicts between managers, shareholders, and bondholders

4. Information asymmetries — “home-made” hedging is a poor substitute for corporate hedging

Each channel corresponds to a violation of one or more MM assumptions. The distress cost channel is the most important — it’s the primary reason most firms hedge. Each channel works by either increasing E[CF] or decreasing the discount rate (or both).

Channel 1: Costs of financial distress

Financial distress = income insufficient to cover fixed obligations.

Direct costs: Liquidation, legal fees, courts.

Indirect costs (often larger):

• Loss of customers who need after-sales service / warranties
• Suppliers demand cash payment or refuse to deliver
• Key employees leave for safer firms
• Loan covenants trigger accelerated repayment
• Forced asset sales at fire-sale prices

Hedging reduces CF volatility \(\Rightarrow\) reduces probability of distress \(\Rightarrow\) reduces expected distress costs \(\Rightarrow\) increases firm value.

This is a cash flow effect: \(E[\text{CF}]\) rises because the probability-weighted cost of bad states falls.

The Slite case

Slite — a Swedish shipping company running ferries between Sweden and Finland.

• Ordered a ship from a German shipbuilder. Payment in DEM.
• Decided not to hedge SEK/DEM exposure because:
  1. SEK was pegged to a basket in which DEM had a large weight
  2. DEM traded at a forward premium — hedging “seemed expensive”

Management confused the forward premium with the cost of hedging.

This is one of the most devastating cases in international finance. The two reasons Slite chose not to hedge are both wrong: (1) pegs can break, and (2) the forward premium reflects interest rate differentials (CIP), not a “cost.” The cost of hedging is the bid-ask spread, which is tiny. The forward premium is the PRICE of the forward contract, not its cost.

The Slite case: what happened

• September 1992: Sweden abandons the link between SEK and DEM.

• By end of 1992: SEK/DEM had depreciated by 30%.

• Slite could no longer afford the ship.

• The vessel was leased by a competitor (Silja).

• Spring 1993: Slite went bankrupt.

Lesson: Without hedging, a single adverse FX move destroyed the firm. The bankruptcy costs — liquidation, loss of business, competitor advantage — are exactly the distress costs that justify hedging.

Channel 2: Tax convexity

Progressive tax rates and loss limitations create a convex tax function:

• Profits are taxed at the full rate
• Losses are not fully deductible (carry-forward limitations, AMT)

With a convex tax function, expected taxes are higher with volatile income than with stable income (Jensen’s inequality):

\[E[\text{Tax}(\tilde{\Pi})] > \text{Tax}(E[\tilde{\Pi}])\]

Hedging smooths income \(\Rightarrow\) reduces expected tax liability \(\Rightarrow\) increases after-tax cash flows.

Tax convexity: example

Setup:

• Invest USD 525,000
• Receive EUR 500,000 in 1 year
• \(S_1 = 1.50\) or \(S_1 = 0.60\) (equal prob.)
• Tax rate: \(\tau = 21\%\)
• Losses are not tax-deductible

Unhedged:

• Good state: \((500\text{K} \times 1.5 - 525\text{K})(1-0.21)\) \(= 171{,}150\)
• Bad state: \((500\text{K} \times 0.6 - 525\text{K})\) \(= -225{,}000\) (no tax offset)
• \(E[\Pi^{UH}] = -26{,}925\)

Hedged (\(F = 1.05\)): \(\Pi^{H} = 500\text{K} \times 1.05 - 525\text{K} = 0\)

Hedging increases value because the tax asymmetry penalizes volatility.

In this example the numbers are chosen to illustrate the principle cleanly. The unhedged firm pays taxes in the good state but gets no tax refund in the bad state. The hedged firm earns zero profit and pays zero taxes. Expected after-tax cash flow is HIGHER when hedged. This is a pure cash flow effect driven by tax convexity.

Channel 3: Agency costs

Manager vs. shareholder conflict:

• Managers have undiversified human capital tied to the firm
• Risk-averse managers may demand higher wages for bearing firm-specific risk
• Managers may reject positive-NPV risky projects to protect their positions
• Hedging aligns manager and shareholder incentives

Shareholder vs. bondholder conflict:

• Near distress, shareholders may gamble on risky projects (risk-shifting)
• Or they may underinvest (refuse to put in equity for safe projects that benefit bondholders)
• Hedging reduces this conflict \(\Rightarrow\) increases debt capacity \(\Rightarrow\) lowers cost of debt

Both are primarily cash flow effects: better investment decisions, lower agency-driven costs.

Channel 4: Information asymmetries

M&M assumes shareholders can hedge themselves. But:

• Shareholders have far less information about firm exposures than managers. Home-made hedging is imprecise.

• Individuals face higher transaction costs, margin requirements, and short-sale constraints.

• Economies of scale allow firms to obtain better terms for forwards and swaps than individual shareholders.

• Forward positions may be prohibitively large for retail investors.

Home-made hedging is a poor substitute for corporate hedging.

This violates M&M’s “equal access to financial markets” assumption.

CF vs. DR: how hedging adds value

Expected cash flow effects (primary):

• Reduces expected distress costs (Channel 1)
• Reduces expected tax liability (Channel 2)
• Improves investment decisions (Channel 3)

Discount rate effects (secondary):

• Lower CF volatility may reduce cost of debt
• Greater debt capacity can lower WACC
• Reducing distress risk may lower systematic risk

The CF channel is primary. When evaluating whether a firm should hedge, first ask: “Does hedging change expected cash flows?”

Arguments Against Hedging

Hedging has costs

1. Transaction costs: Bid-ask spreads on forwards, option premia, commissions

2. Cost of expertise: Risk management staff, systems, monitoring

3. Operational risk: Hedging errors, unauthorized trading, model risk

These costs must be weighed against the benefits. For most large firms with significant FX exposure, the benefits dominate.

Other concerns

• Hedging operating exposure is difficult: Long-term, uncertain amounts, competitive effects are hard to capture with financial instruments

• Bad incentives: Hedging programs can become speculative (“we’ll hedge only when we think the rate is going against us”)

• Shareholder diversification: Some investors may prefer unhedged exposure for portfolio diversification purposes

• Signaling: Hedging may signal to the market that the firm has significant exposure, drawing attention to risks

These are real concerns, but they argue for careful hedging, not for no hedging.

Empirical Evidence

What risks do firms hedge?

Source: “Managing Risk Management” by Bodnar, Graham, Harvey, and Marston (2011).

FX risk is the #1 risk managed with derivatives, followed by interest rate risk. This is consistent with the fact that FX exposure is the most direct and measurable for multinational firms.

Derivative usage by firm size

Source: Bodnar, Graham, Harvey, and Marston (2011).

Larger firms are much more likely to use derivatives. This is consistent with the economies-of-scale argument: larger firms can justify the fixed costs of a risk management program. It also reflects the fact that larger firms tend to have more international operations and more FX exposure.

Which instruments?

Source: Bodnar, Graham, Harvey, and Marston (2011).

Forward contracts dominate for FX hedging — consistent with what we learned in Lectures 4-5. Forwards are the simplest, most flexible, and cheapest instrument for hedging known future cash flows. Options are used less frequently, typically for contingent exposures or when downside protection is needed without giving up upside. Swaps are used more for interest rate management.

Why do firms hedge?

Source: Bodnar, Graham, Harvey, and Marston (2011).

The #1 reason firms give for hedging is “managing volatility in cash flows” — this is exactly the distress cost / tax convexity channel. “Reducing risk relative to peers” and “managing balance sheet” are also prominent. Note that firms rarely cite “increasing firm value” directly — they think in terms of the operational benefits of stable cash flows.

Hedging objectives

Source: Bodnar, Graham, Harvey, and Marston (2011).

Summary

Summary

• Under M&M, hedging does not affect firm value — shareholders can hedge themselves.

• In reality, frictions make hedging valuable:

  • Costs of financial distress (primary channel)
  • Tax convexity (progressive rates + loss limitations)
  • Agency costs (manager-shareholder, shareholder-bondholder)
  • Information asymmetries (home-made hedging fails)

• Hedging primarily increases \(E[\text{CF}]\) (and may reduce the discount rate).

• The majority of firms hedge in practice. FX is the #1 risk managed with derivatives.

Next: How to measure exposure — transaction, translation, and operating — and how to design hedging strategies.