Why Hedge?

1
Why Hedge?
2
Objective

• Discuss the pros and cons of hedging

3
Outline

• Discussion
• Exemplification

4
Lack of consensus

• In the financial world there is no consensus on
  whether a firm should hedge.
• Arguments
• Hedging is costly
• Hedging exchange risk exposure is redundant
• - Stockholders can do their own home-made hedging
  (similar argument to MM leverage irrelevance
  theory).
• There are companies that choose not to hedge
  their currency exposure.

5
The case for hedging Market imperfections

• Information asymmetry
• Managers have better information about firm's
  risk position
• Economies of scale easy access
• Managers are in a position to acquire low-cost
  hedges
• Cost of bankruptcy
• When default costs are significant, hedging may
  reduce those costs, hence improving the credit
  rating of the company (risk position shift)
• Tax argument
• Under progressive corporate tax rates, firms pay
  more taxes in high earning periods than it saves
  in low earning periods.
• The lower the variance of profits, the lower the
  average tax liability (tax advantage)

6
Tax argument illustrated
Consider the following tax rates
7
Consider two companies with identical expected
cash flows, but with different level of risk
8
Conclusion 1

• Hedging reduces the tax bill

9
Consider two companies with different expected
cash flows, and with different level of risk
10
Conclusion 2

• Hedging reduces the tax bill