Chapter 17
Risk Management
and the Foreign
Currency Hedging
Decision
Slides prepared by
April Knill, Ph.D., Florida State University
17.1 To Hedge or Not To Hedge
• Hedging = risk mitigation
• Forward contracts
• Futures
• Options
• Risk management – should firms hedge?
• Modigliani and Miller (1958; 1961) - indifferent
• Usually involves 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
• Makes sense for entrepreneurs (assuming
exposure to forex) because
• Future forex rates are difficult, if not impossible, to
predict
• Firm is unable to diversify risks as most investors can
so for the entrepreneur it is a good enough reason if
he/she is risk-averse
•
Reducing the variance of profits increases the entrepreneur’s expected
utility
• More difficult for publicly held corporations
• Hedging must increase the equity value of the firm (e.g.,
one of the terms in ANPV) or it must decrease the market
value of debt to be worthwhile
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17.1 To Hedge or Not To Hedge
• The Hedging-is-Irrelevant Logic of Modigliani and
Miller
• Modigliani-Miller proposition
• 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
• Investors can hedge on their own and they can always
undo the hedging the firm does (assuming they have the
same opportunity set)
• Problems with theory
• Assumptions are not real world, e.g., individuals don’t
always have the same opportunities and even if they did,
they aren’t going to pay the same amount for them
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17.2 Arguments Against Hedging
• Hedging is costly
• Bid-ask spread – larger in forward market
• Salaries and monitoring costs of employees to evaluate
hedging alternatives
• Hedging equity risk is difficult, if not impossible
• Weehawken Widget Project – either £125 or £75 for
every year from next year into infinity
• E[0.5*£75 + 0.5*£125] = £100
• Discounted @ 10%, that is £1,000  @ $2/£  $2,000
• With a cost of $1,900, profit=$100
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Exhibit 17.1 The Value of Weehawken’s
Project with Unhedged Cash Flows
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17.2
Arguments Against Hedging
• Forex rate can go up or down by $0.20/£ with
equal probability
– Expectation is $2.00/£ and discount rate = 10%
– For top-left figure:
–
[($2.20/£)*£125] + [($2.20/£)*£1,000] = $2,475
$ Value of time
t+1 £ CFs
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$ Value of infinite stream
of £ CFs (still has same PV)
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Exhibit 17.2 The Value of Weehawken’s
Project with 2-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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17.2
Arguments Against Hedging
• If Weehawken hedges the 1st two years’ cash flows
then the calculation changes:
– Hedge: expectation is $2.00/£ and CF = £100
– For top-left figure:
– [($2.00/£)*£100] + [($2.20/£)*£25] +
$ Value of hedged £CFs
$ Value of unhedged £CFs
– [[($2.00/£)*£100]/1.1] + [[($2.20/£)*£1,000]/1.1] =
$2,436.82
$ Value of hedged £CFs
$ Value of infinite stream
of £ CFs (still has same PV)
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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
• If Weehawken hedges ALL of their cash flows then the
calculation becomes:
– Expectation is $2.00/£ and CF = £100
– For top-left figure:
– [($2.00/£)*£100] + [($2.20/£)*£25] +
$ Value of hedged £CFs
Infinity comes in here
$ Value of unhedged £CFs
– [[($2.00/£)*£100]/1.1] + [($2.00/£)*£100]/1.12 + … = $2,255
$ Value of hedged £CFs
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$ Value of hedged £CFs
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
• Hedging can reduce the firm’s expected
taxes
• Tax-loss carry forward: “refund” from
government when you are unprofitable
• However, NOT paid immediately and is carried
forward - since $1 today is worth more than a $1
tomorrow we’d rather just avoid the loss
• Limit to the amount of time you can carry it forward
• Convex tax code: imposes a larger tax rate on
higher income (and smaller on lower income)
• Examples include progressive tax system (like ours in
the U.S.) and if tax losses are carried forward
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Exhibit 17.5 A Convex Income Tax
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17.3
Arguments for Hedging
– 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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17.3 Arguments for Hedging
Example 1
Starpower has a project that provides CHF40M in 1year and costs $19M.
Assume forex rate will either be $0.55/CHF or $0.45/CHF (equal probability).
Starpower can claim a refund (at tax rate) on its losses.
UNHEDGED
[($0.55/CHF)*CHF40MM] - $19M = $3M or
[($0.45/CHF)*CHF40MM] - $19M = -$1M
The expectation is [0.5*$3M]+[0.5*-$1M]=$1M
Including taxes (@35%):
[0.5*$3M*(1-0.35)]+[0.5*(-$1M)*(1-0.35)]=$675,000
HEDGED
1-year Forward rate=$0.50/CHF
[0.5*($0.55/CHF)]+[0.5*($0.45/CHF)] = $0.50/CHF
Hedging fully: ($0.50/CHF)*CHF40M = $20M – $19M=$1M
After taxes: $1M*(1-0.35) = $650,000
Hedging allows for a reduction in income variance but no after-tax gain
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17.3 Arguments for Hedging
Example 2 (Example 1 with Convex Taxes)
Same project but Starpower can only claim a 25% refund on its losses. Taxes
remain 35%.
UNHEDGED:
[($0.55/CHF)*CHF40M] - $19M = $3M or
[($0.45/CHF)*CHF40M] - $19M = -$1M
The expected value of the after-tax income:
[0.5*$3M*(1-0.35)]+[0.5*(-$1M)*(1-0.25)]=$600,000
Expected tax bill = the difference between expected before-tax income of $1M
and the expected after-tax income of $600,000:
$1M-$600,000 = $400,000
HEDGED:
Hedging fully: ($0.50/CHF)*CHF40M = $20M – $19M=$1M
After taxes: $1M*(1-0.35) = $650,000 (same as in Example 1)
Decrease in tax obligation from hedging:
$400,000 - $350,000 = $50,000
Convex tax system provides an incentive to get rid of income variance
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17.3 Arguments for Hedging
Example 3 (Ex. 2 with greater variance)
What if the possible exchange rates change to $0.60/CHF and $0.40/CHF?
UNHEDGED
[($0.60/CHF)*CHF40M] - $19M = $5M or
[($0.40/CHF)*CHF40M] - $19M = -$3M
The expectation is [0.5*$5M]+[0.5*-$3M]=$1M
The expected value of the after-tax income:
[0.5*$5M*(1-0.35)]+[0.5*(-$3M)*(1-0.25)]=$500,000
Expected tax bill = $1M-$500,000 = $500,000
HEDGED
Hedging fully: ($0.50/CHF)*CHF40M = $20M – $19M=$1M
After taxes: $1M*(1-0.35) = $650,000 (same as in Example 1)
Increase in after-tax earnings from hedging: $150,000
The more volatile the income, the greater the expected tax savings
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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,
i.e., the expected costs of financial distress (Smith and
Stulz, 1985)
• Hedging can improve the firm’s future investment
decisions
• If firm did not hedge and its value fell, (+) NPV projects
may be missed
• Froot, Scharfstein and Stein (1993) argue that hedging
raises firm value in that it provides a definite stream of
income to finance growth opportunities such as R&D
activities
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17.3 Arguments for Hedging
• Hedging can change the assessment of a
firm’s managers
• DeMarzo and Duffie (1995) find that manager
quality is gauged by earnings information. Hedging
increases the informational content of a firm’s
profits about managers’ ability
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17.4 The Hedging Rationale of Real Firms
• Leading pharmaceutical with $103.7 Billion in
sales (1988) in an industry that was not
concentrated
• Exposure
• 70 subsidiaries around the world
• 50% of revenue from foreign sources
• Period of dollar strengthening
• Price takers
• One idea: to develop natural operating hedges
• Using operations to provide a better balance between costs and
revenues (in specific currencies)
• Not possible because they wanted to keep most of the R&D in
the U.S.
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17.4 The Hedging Rationale of Real Firms
Merck’s 5-Step Procedure
1. Develop forecasts to determine probability of adverse exchange
rate movements
• Consider economic fundamentals, government interference,
past forex rates, professional forecasts
2. Assess the impact of exchange rate changes on firm’s 5-year
strategic plan
• Sensitivity analysis
3. Decide whether to hedge currency exposure
• Hedge on a case by case basis
4. Select appropriate hedging instrument
• Options since they could then benefit from potential gains of a
weakening dollar
5. Simulate alternative hedging programs to select most cost
effective
• Long-term options, avoid far-out-of-the-money options and
partially self-insure
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17.5 Hedging Trends
• Information from surveys
• Nance, Smith and Smithson (1993)
• Large R&D firms hedge
• Highly levered firms hedge
• Firms with higher dividend yields hedge
• 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
• Evidence that operational hedging is undertaken
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17.5 Hedging Trends
• Geczy, Minton and Schrand (1997)
•
41% use swaps, forwards, futures, options or combination of these
•
Firms with greater growth opportunities are more likely to use
derivatives
•
Issuing debt in foreign currency serves same function as hedging
instruments
• Bartram, Brown and Fehle (2009)
•
Tax factors and high leverage are important
•
Large firms with high M/B ratios
•
Firms with larger foreign exchange exposure
• Financial effects of hedging
• Allayannis and Weston (2001) find that hedging
increases the value of firms by 5%
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17.5 Hedging Trends
• Deciding whether to hedge or not
• What is industry norm and is there a good reason to
divert from it?
• Is your competition foreign or domestic?
• Will changes in the real exchange rate inhibit your
competitiveness?
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