International-Financial-Management---Bekaert-2e---Solutions---Ch17.doc
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International-Financial-Management---Bekaert-2e---Solutions---Ch17.doc
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Chapter17:
RiskManagementandtheForeignCurrencyHedgingDecision
Chapter 17
RiskManagementandtheForeignCurrencyHedgingDecision
QUESTIONS
1.Whywouldanentrepreneurfinditdesirabletohedgehisorherforeignexchangerisk?
Answer:
Anentrepreneurwouldfinditdesirabletohedgeforeignexchangeriskbecausetheprofitsfromtheentrepreneurialventureareasignificantpartoftheentrepreneur’swealth.Unlikeregularinvestors,entrepreneursareunabletodiversifyawaysuchrisksthroughtransactionsintheirownportfolios.Hence,ifforwardratesareunbiasedpredictorsoffuturespotrates,risk-averseentrepreneurswillchoosetohedgetheirfutureforeigncurrencycashflowsbecausedoingsowillreducethevarianceoftheflowswithoutchangingtheirexpectedvaluesinthedomesticcurrency.Therefore,reducingthevarianceoffutureprofitswouldincreasetheentrepreneur’sexpectedutility.
2.ExplainModiglianiandMiller’sargumentthathedgingisirrelevant.WhatarethemostlikelyviolationsofModiglianiandMiller’sassumptionsinactualmarkets?
Answer:
ModiglianiandMillerarguedthatacorporation’sfinancialpolicies,suchasissuingdebt,hedgingforeignexchangerisk,andotherpurelyfinancialriskmanagementactivities,donotchangethevalueofthefirm’sassetsunlessthesefinancialtransactionslowerthefirm’staxes,affectitsinvestmentdecisions,orcanbedonemorecheaplythanindividualinvestors’transactionscanbedone.
Thereasonthatreducingtheuncertaintyoffuturecashflows,perse,doesnotleadtoarationaleforhedgingisthatitmaynotchangeinvestors’perceptionsofthefirm’ssystematicrisk.Weknowfrommodernportfoliotheorythattherequiredrateofreturnontheequitycashflowsofacorporationdoesnotdependonthestandarddeviationofthefirm’scashflowsbutonlyonthesystematicriskassociatedwiththosecashflows.Thefactthatafirm’scashflowsareuncertainisanecessarybutnotasufficientconditionfordiscountingthecashflowsatadiscountratehigherthantherisk-freeinterestrate.Hence,unlikeinthecaseofanentrepreneurialfirm,ifhedgingmerelyreducestheunsystematicriskofthecorporation’scashflowswhileleavingunchangedboththesystematicriskandtheexpectedvalueofthecashflows,hedgingwillnothaveanyeffectonthefirm’svalue.Investorswillstilldiscountthesameexpectedcashflowsatthesamerequiredrateofreturnthatisappropriateforthefirm’ssystematicrisk.
TheassumptionsofModiglianiandMillerarestrong.Theinvestmentpolicyofthefirmisprobablynotinvarianttothehedgingdecisionsofthefirmbecauseoftheasymmetricinformationenvironmentinwhichthefirmoperates.Aprimaryargumentforhedgingistoassurethemanagementofasufficientlylargeinternallygeneratedcashflowsothattheinvestmentdecisionsofthefirmarenotaffectedbyadversefluctuationsinexchangerates.Hedgingalsoprobablycanreducethetaxesthatafirmpaysbyshiftingincomefromgoodstatesoftheworldinwhichthefirmisprofitabletobadstatesoftheworldinwhichthefirmwouldotherwisebeunprofitable.
3.Supposethatafterjoiningthetreasurydepartmentofalargecorporation,youfindoutthatitavoidshedgingbecausethecostofhedgingcomesoutofthetreasurydepartment’sbudget.WhatargumentcouldyoumaketotheCFOtogetthefirminterestedinlettingyoubethefirm’shedgingguru?
Answer:
Thereissomethingwrongwiththefirmiflossesonhedgesarebookedtotreasurywhereasthegainsontheunderlyingassetsthatarebeinghedgedarebookedsomewhereelse.YoushouldexplaintotheCFOthathedgingisaboutavoidinglossesthatwouldadverselyaffecttheperformanceofthefirm.Hedginginvolvesinvestinginderivativesecuritieswhosevaluesgodownwhentheunderlyingassetsofthefirmgoupinvalue,whilethevaluesofthederivativesecuritiesrisewhentheunderlyingassetsofthefirmfallinvalue.
Itisappropriateforthecostsofhedgingtobebornebythetreasurydepartment,butthesecostsshouldbethepersonnelcostsforthosewhoareinvolvedintheprocess.
4.YourCFOthinksthatthevalueofyourfirmfluctuatesenormouslywiththeyen–dollarexchangerate,buthedoesnotwanttohedgebecausehethinksitisanimpossiblerisktohedge.Canyouconvincehimotherwise?
Answer:
Ifthevalueofthefirmfluctuateswiththeyen-dollarexchangerate,thefirmmustfirstdeterminethesignofthecovariance.Supposethatthevalueofthefirmgoesupwhentheyenstrengthensrelativetothedollarandthevalueofthefirmislowwhentheyenisweakversusthedollar.Then,thefirmeffectivelyhasyenassetswhosedollarvalueincreaseswhentheyenappreciates.Anappropriatehedgewouldbetodenominatesomeofthefirm’sdebtinyen,therebygettingyenliabilitieswhichincreaseinvaluewhentheyenstrengthens.Thefirmcouldalsosellyenforward.Thedollarprofitsorlossesonthesecontractswouldbe
Therewouldbeprofitwhenthefutureexchangerateofyenperdollarroseunexpectedly,thatis,whentheyenweakenedandthevalueofthefirmwaslow.Finally,thefirmcouldbuyyenputs,whichwouldgivethefirmtherightbutnottheobligationtosellyenatafixedstrikepriceofdollarsperyen.Thesecontractswouldalsoprovideprofitwhenthedollarstrengthenedrelativetotheyen.
Thatbeingsaid,theCFOhasapoint.Itisimpossibletohedgethefullvalueofthefirmbecauseitdependsonaninfiniteseriesofcashflowswithmuchofthefirm’svaluecomingfromcashflowsinthefardistantfuture.
5.Whatdoesitmeanforataxcodetobeconvex?
Ifacountry’scorporatetaxrateisflat,doesitmakesenseforafirmtohedge?
Answer:
Aconvextaxcodeimposesalargertaxrateonhigherincomesandasmallertaxrateonlowerincomes.Ifacountry’staxrateisflat,akeyquestionishowlossesaretreated.Iflossesaresubsidizedimmediatelyatthesameratethatgainsaretaxed,thereisnotaxadvantagetohedging.But,lossesareusuallynotsubsidized,aslossesaretypicallyonlyallowedtobedeductedagainstfutureincome.Thesetax-losscarry-forwardsusuallydonotgrowwiththetimevalueofmoney;noraretheyindexedtoinflation.Thus,thesubsidyassociatedwithalossislessthanthetaxassociatedwithaprofit,andthetaxcodeiseffectivelyconvex.Therearealsootherlegitimatereasonstohedgethatarenottaxrelated.
6.Ifthetaxcodeisconvexandtheforwardrateequalstheexpectedfuturespotrate,whywouldafirmprefertopaytaxesonthehedgedvalueofaforeigncurrencycashflowratherthanwaittopaythetaxesontherealizedforeigncurrencycashflow?
Answer:
Inthepresenceofaconvextaxcodeandiftheforwardrateequalstheexpectedfuturespotrate,afirmwouldprefertopaytaxonitsexpectedincomewithcertaintyratherthanpayingitsexpectedtaxbytakingtheprobabilityweightedaverageofthetaxesonpossibleincomesintheuncertainfuturestatesoftheworld.Thisisbecausehedgingallowsthefirmtoshiftincomeacrossdifferentstatesoftheworld.Increasingincomeinstateswithlossesavoidsthelowsubsidyrates,andthushedgingreducesexpectedtaxes.Thisincreasesthefirm’svalue.
7.Whyisthegaininafirm’svaluegreaterwhenmoreofitsfutureforeigncurrencyincomeisinthelowtaxregionofthetaxcode?
Answer:
Thisquestionissomewhatpoorlyphrased.Ifallofthefirm’sforeigncurrencyincomeaccruedinthelowtaxregionofthetaxcode,therewouldbenogaintohedging.Thegaininafirm’svalue(fromhedging)arisesfromtheabilitytoshiftincomefromstatesinwhichitissubjecttohightaxestostatesinwhichitissubjecttolowtaxes.
8.WhywouldthemanagersofafirmtakeaforeignprojectwithalowerdomesticcurrencyNPVandahigherreturnvarianceratherthanaforeignprojectwithahigherdomesticcurrencyNPVbutalowerreturnvariance?
Answer:
ThisisanexampleoftheassetsubstitutionissuethatwecoveredinChapter16.Becauseshareholdersonlygainingoodstatesoftheworld,theylikethevarianceofthefirmtobehigh.Whenthevarianceofthefirmishigher,theshareholdersgainmoreinthegoodstatesoftheworld.Thebondholdersgetpaidtheirfullamountingoodstatesoftheworld,andtheygetthevalueofthefirminthebadstatesoftheworld.Byacceptingahighvarianceproject,managersmaybeabletoshiftsomevaluefrombondholderstoshareholdersinanassetsubstitution.
9.WhywouldafirmeverforgoapositiveNPVproject?
Howcanhedginghelppreventthissituationfromarising?
Answer:
Ifthefirmhasdebtinitscapitalstructure,weknowthatthemanagersmayforegoapositiveNPVinvestmentthatmustbefinancedbyshareholdersbecausetoomuchoftheincreaseinfirmvalueaccruestobondholders.Ahedgingpolicycanhelptoavoidsuchassituationbyavoidingthelossesthatmayplungethefirmintofinancialdistressandmakethedebtriskyinthefirstplace.Byreducingthevarianceofincome,thehedgingpolicymakesthedebtlessriskyinwhichcaseitsellsforapriceclosertofacevalue.
10.Supposethecashflowsfromfinancialhedgingarepooledwiththecashflowsfromafirm’soperationsandthattheshareholderscannotascertaintheultimatesourcesofprofitsandlosses.Wouldthemanagersofthefirmwanttohedgeortospeculateintheforwardforeignexchangemarket?
Answer:
ThePeterDeMarzoandDarrellDuffie(1995)argumentisthefollowing.Shareholdersmustgaugethequalityofthefirm’smanagersbasedontheirobservationsofthefirm’sprofitabilityanditsearnings,asdisclosedinitsaccountingdata.Fromthis
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