09
Should Firms Hedge?
by admin ·
Hedging can reduce the volatility of cash flows. But does this add shareholder value? Maybe, but it should not usually be a first-order effect for two reasons. First, our shareholders should care little about the idiosyncratic currency risk our corporation faces, because they are heavily diversified. As long as the foreign currency does not comove with the (U.S.) stock market, any extra currency risk should not change the U.S. market beta. For our investors’ portfolio, currency fluctuations across many different companies—some net exporters, some net importers—should mostly wash out. Second, if our shareholders dislike the risk of losing money when the euro goes up or down, they can themselves buy the proper currency forward hedges to neutralize any such risks.
Still, many corporations hedge currency fluctuations. Why? There are a number of possible explanations, but they are probably only second-order effects. Here are some examples.
• If adverse currency fluctuations could lead a firm to incur financial distress, the resulting costs to handle the financial distress are quite real. (In a sense, hedging is really just like capital structure policy—the first-order effect should be that firms should be worth what the underlying operations are worth, which should not strongly depend on how the firm is financed. But if a firm is close to financial distress, too much debt can cost value.)
• Managerial and corporate performance may be easier to evaluate if the firm can reduce the effects of unexpected currency fluctuations. This can reduce agency problems.
• Managers may just not like the uncertainty of currency fluctuations, and try to neutralize this risk even if it does not increase value.
Sadly, many firms hedge because they believe they can outguess the financial markets and thereby increase their profits. This is often a sign of poor control, because the compensation of lower-level employees who handle the hedging often implicitly or explicitly depends on the profitability of their hedges. Therefore, these employees often participate more in the upside than in the downside of their contracts. Thus, they may be quite willing to gamble with shareholders’ money.