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1、ChapterChapter1717RiskManagementandtheForeignCurrencyHedgingDecisionFirmshedgeforeignexchangeriskbyusinginstrumentssuchasforwardandfuturesforeignexchangecontracts,interestrateandcurrencyswaps,andforeigncurrencyop-tionsandbychoosingtodenominateassetsandliabilitiesinforeigncurrencies.Forexample,Inf
2、osys,anIndiansoftwarefirm,hasasix-personTreasuryteaminBangalore,India,thatroutinelyhedgesitscurrencyriskonetotwoquartersahead.TheriskissubstantivebecausethefirmhasmostofitscostsinIndianrupeesand98%ofitsrevenueinforeigncurrencies.Infosysestimatesthatitloses40basispointsofprofitmarginforeach1%thatt
3、heIndianrupeedepreciatesagainsttheU.S.dollar.Thischapterexamineswhyafirmwouldwanttousethesefinancialinstrumentstohedgeforeignexchangerisk.Wefirstshowthathedgingwouldbedesirableforarisk-averseentrepreneurbecauseitreducesthevarianceofprofits.However,inamodern,publiclyheldcorporation,thebenefitsofhe
4、dgingarelessclear.Indeed,thelogicofModiglianiandMiller(1958,1961)impliesthathedgingisirrelevantasinvestorscanalwaysundoanyhedgingacorporationdoes.Neverthe-less,therearemodernargumentsforandagainsthedging,andweknowthattheassumptionsofModiglianiandMillerprobablydonotholdformostsituations.Afterrevie
5、wingtheModigliani–Millerarguments,weexaminethreeargumentsagainsthedging:thathedgingiscostly,thathedgingisimpossibleforequity-likecashflows,andthathedgingincreasesthecostsoffinancialdistressbyexposingbondholderstoapossiblebaitandswitch.However,hedgingcanbevaluable!Hedgingisvaluablebecauseitcanredu
6、cethefuturetaxesthatafirmexpectstopay.Hedgingcanlowerthecostsoffinancialdistress,anditcanimprovetheinvestmentdecisionsthefirmwillfaceinthefuture.Whenthereisasymmetricinformationbetweenthemanagersofafirmanditsstockholders,hedgingmayalsoaffecttheabilityofstockholderstoevaluatethequalityofthemanagem
7、ent.Weendthechapterbytakingalookatthepracticeofhedging.Asacasestudy,weexaminethelogicbehindMerck’sdecisiontohedgeitsforeignexchangeriskwithforeigncurrencyoptions.Then,weexamineacademicstudiesandsurveysthathavesoughttod
