Chapter 13 The Rationale for Hedging Currency Risk

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Chapter 13 The Rationale for Hedging Currency
Risk

• 13.1 A Perfect Model for an Imperfect World
• 13.2 When Hedging Adds Value
• 13.3 Convexity in the Tax Schedule
• 13.4 Costs of Financial Distress
• 13.5 Agency Costs
• 13.6 The Hedging Decision
• 13.7 Summary

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The perfect market assumptions

• No market frictions
• No transactions costs
• No taxes or government intervention
• No costs of financial distress
• No agency costs
• Equal access to market prices
• Perfect competition
• No barriers to entry
• Rational investors
• Return is good and risk is bad
• Equal access to costless information

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Perfect financial marketsand corporate financial
policy

• If financial markets are perfect, then financial
  policy is irrelevant.
• If financial policy is to increase firm value,
  then it must either increase the firms expected
  future cash flows or decrease the discount rate
  in a way that cannot be replicated by individual
  investors.

4
Perfect financial marketsand risk hedging

• If financial markets are perfect, then corporate
  hedging policy has no value.
• If corporate hedging policy is to increase firm
  value, then it must either increase the firms
  expected future cash flows or decrease the
  discount rate in a way that cannot be replicated
  by individual investors.

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When hedging matters

• Convexity in the tax schedule
• Progressive taxation
• Tax preference items
• Tax loss carryforwards and carrybacks
• Investment tax credits
• Costs of financial distress
• Direct versus indirect costs
• Lost credibility (sales, expenses, etc.)
• Conflicts of interest between debt and equity
• Agency costs
• Conflicts of interest between managers and other
  stakeholders

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Progressive taxation
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Progressive taxation
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The value of U.S. tax incentives to hedge

• Graham and Smith simulate the tax savings
  achieved through hedging within the U.S. tax
  code.
• A 5 percent reduction in the variability of
  taxable income results in a 3 percent reduction
  in taxes for U.S. firms
• This is a savings of 142,360 for the typical
  NYSE/AMEX firm
• In some cases, tax savings from a 5 percent
  reduction in the variability of taxable income
  approach 8 percent.
• John R. Graham and Clifford W. Smith, Tax
  Incentives to Hedge, Journal of Finance 54,
  1999.

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Equity as a call option

• Suppose the promised payment to bondholders is
  1,000.
• Firm value will be either 750 or 1,750 with
  equal probability

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Hedging in the absence of costs of financial
distress

• Unhedged Firm value is either 750 or 1,750
• EVBONDS (½)(750) (½)(1,000) 875
• EVSTOCK (½)(0) (½)(750) 375
• EVFIRM (½)(750) (½)(1,750) 1,250
• Hedged Firm value is 1,250 for certain...
• EVBONDS 1,000
• EVSTOCK 250
• EVFIRM 1,250

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The effects of hedging in the absence of costs
of financial distress

• A zero-sum game
• In the absence of costs of financial distress,
  hedging creates no value for the firm.
• Risk shifting
• Hedging when there is already debt outstanding
  transfers wealth from shareholders to
  bondholders.
• The benefits of a hedging policy
• Instituting a hedging plan prior to borrowing can
  benefit shareholders by reducing borrowing costs.

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The equity call optionwith direct bankruptcy
costs

• The firm must pay 500 in bankruptcy.

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Hedging with direct bankruptcy costs

• Unhedged EVBONDS (½)(250) (½)(1,000)
  625
• EVSTOCK (½)(0) (½)(750) 375
• EVFIRM (½)(250) (½)(1,750) 1,000
• Hedged EVBONDS 1,000
• EVSTOCK 250
• EVFIRM 1,250
• Hedging can preserve value in the presence of
  direct bankruptcy costs.
• Equity gains if the size of the wealth shift to
  debt is less than the gain in firm value from
  hedging.

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Direct and indirect costs of financial distress

• Direct costs in bankruptcy Þ 500 if bankruptcy
  occurs
• ...changes the payout to debtholders if
  bankruptcy occurs
• Indirect costs of financial distress Þ 250 prior
  to bankruptcy
• ...changes the distribution of firm value prior
  to bankruptcy

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The equity call option with direct and indirect
costs of financial distress

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Hedging with direct and indirectcosts of
financial distress

• Unhedged EVBONDS (½)(0) (½)(1,000) 50
  0
• EVSTOCK (½)(0) (½)(500) 250
• EVFIRM (½)(0) (½)(1,500) 750
• Hedged EVBONDS 1,000
• EVSTOCK 250
• EVFIRM 1,250
• Hedging can preserve value in the presence of
  costs of financial distress.
• Equity gains if the size of the wealth shift to
  debt is less than the gain in firm value from
  hedging.

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Costs of financial distress and risk hedging

• Hedging can increase expected cash flows by
  reducing the costs of financial distress.
• Hedging reduces the required return of debt and
  hence the cost of capital to the firm.
• Equity may or may not benefit from risk hedging
  depending on whether the increase in firm value
  is more or less than the value transfer to debt
  from the reduction in risk.