Why Hedge? The value of a firm,according to financial theory,is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows
Why Hedge? The value of a firm, according to financial theory, is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows
Exhibit 9.2 Impact of Hedging on the Expected Cash Flows of the Firm --Hedging reduces risk (variance)but it does not add value (in fact there is a cost) Hedged Unhedged NCF Net Cash Flow(NCF) Expected Value,E(V) Hedging reduces the variability of expected cash flows about the mean of the distribution. This reduction of distribution variance is a reduction of risk
Exhibit 9.2 Impact of Hedging on the Expected Cash Flows of the Firm --Hedging reduces risk (variance) but it does not add value (in fact there is a cost)
Arguments for not hedging Hedging may eliminate potential gains from an increase in the value of the asset 2 Hedging is not free consumes some resources (CF,time etc.) 3 Agency theory management may not always act in the best interest of the shareholders(management is often more risk-averse than shareholders) 4 Shareholders are capable of diversifying currency risk
Arguments for not hedging Hedging may eliminate potential gains from an increase in the value of the asset 2 Hedging is not free - consumes some resources (CF, time etc.) 3 Agency theory - management may not always act in the best interest of the shareholders (management is often more risk-averse than shareholders) 4 Shareholders are capable of diversifying currency risk
Arguments in favour of hedging: Reduction in risk in future cash flows --1 Improves the planning capability of the firm --2 Reduces the likelihood that the firm's cash flows will fall below a necessary minimum (financial distress) 2 Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm 3 Management can use selective hedging
Arguments in favour of hedging: Reduction in risk in future cash flows --1 Improves the planning capability of the firm --2 Reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (financial distress) 2 Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm 3 Management can use selective hedging
Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations in a foreign currency. Transaction exposure arises from e.g. --1 Purchasing or selling on credit where prices are stated in foreign currency --2 Borrowing or lending in a foreign currency --3 Entering a forward contract Transaction exposure is the chance of either a loss or a gain!
Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations in a foreign currency. Transaction exposure arises from e.g. --1 Purchasing or selling on credit where prices are stated in foreign currency --2 Borrowing or lending in a foreign currency --3 Entering a forward contract Transaction exposure is the chance of either a loss or a gain!