Many firms attempt to manage their currency (foreign exchange) exposures through hedging. Hedging is the taking of a position, acquiring either a cash flow, an asset, or a contract (e. g.
, a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position While hedging can protect the owner of an asset from a loss, it also eliminates any gains from an increase in the value of that asset. A major motive for firms to hedge is to increase the present value of firms.The value of a firm is the present value of all expected future cash flows in the future. For expected cash flows with higher risk, a higher discount rate should be applied to calculating the present value and thus a lower present value for these cash flows is generated A firm that hedges these foreign exchange exposures reduces the risk in the value of future expected cash flows (see Exhibit 11. 2) (Eiteman, D.
K, Stonehill, A. I, Moffett, M. H 2009).Therefore a lower discount rate is used to calculate the present value of likely future cash flows, which increases the present value of the firm.
However opponents of currency hedging argue the following, saying that a reduction in the variability of future cash flows is not sufficient enough. Firstly, shareholders are more capable of spreading out currency risk according to their individual preferences and risk tolerance instead of the management of the firm. (Eiteman, D. K, Stonehill, A.
I, Moffett, M. H 2009).Secondly, currency risk management can reduce the variance reducing the expected cash flow due to hedging costs meaning that the real benefit of hedge depends on the trade-off between these two effects. Thirdly, shareholders often feel that hedging activities are sometimes conducted to benefit the management at their expense, for example, thinking the main use of hedging is to ensure the bonus of the management and they may overuse the expensive hedge. (Eiteman, D.
K, Stonehill, A. I, Moffett, M. H 2009). However management may think that it will be criticized more harshly for gaining foreign exchange losses than for similar or higher hedge costs in avoiding the foreign exchange loss possibly because hedging costs are buried in operating or interest expenses.
Fourthly, efficient market theorists believe that investors can see through the “accounting veil” and therefore have already factored the foreign exchange effect into a firm’s market valuation. However, Hedging can reduce the variance of future cash flows and thus may increase the firm’s present value by reducing the discount rate.Firms should focus on the main business they are in and take activities to minimize risks arising from interest rates, exchange rates, and other market variables Management is in better position than shareholders to recognize disequilibrium conditions quickly and to undertake the hedging activities immediately Management has a comparative advantage over individual shareholders in estimating the actual currency risk of the firm and taking the correct hedging strategy Reduction in risk in future cash flows improves the planning capability of the firm.Therefore, the firm can undertake more investment projects that it might not consider before Since a firm must generate sufficient cash flows to make debt-service payments, reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum (This minimum level of cash flows is also terms as the point of financial distress)
