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In 2016 Ford Motor Company won the Corporate Risk Manager of the Year award from Risk. net. Brian Schaaf, an assistant treasurer at Ford's corporate headquarters, explained how Ford's risk management had changed. He stated, “Prior to the financial crisis, risk management activities, such as currency and interest rate hedging, were done by separate treasury departments. Now, these hedging activities have been consolidated into a single treasury risk management function, and we're approaching it with a more holistic focus on the macro environment, risk relationships, and potential strategic implications for the business.”1 Firms, like Ford, hedge foreign exchange risk by using instruments such as forward and futures foreign exchange contracts, interest rate and currency swaps, and foreign currency options and by choosing to denominate assets and liabilities in foreign currencies. This chapter examines why a firm would want to use these financial instruments to hedge foreign exchange risk.
We first show that hedging would be desirable for a risk-averse entrepreneur because it reduces the variance of profits. However, in a modern, publicly held corporation, the benefits of hedging are less clear. Indeed, the logic of Modigliani and Miller (1958, 1961) implies that hedging is irrelevant as investors can always undo any hedging a corporation does. Nevertheless, there are modern arguments for and against hedging, and we know that the assumptions of Modigliani and Miller probably do not hold for most situations.
After reviewing the Modigliani–Miller arguments, we examine three arguments against hedging: that hedging is costly, that hedging is impossible for equity-like cash flows, and that hedging increases the costs of financial distress by exposing bondholders to a possible bait and switch. But, hedging can be valuable!
Hedging is valuable because it can reduce the future taxes that a firm expects to pay. Hedging can lower the costs of financial distress, and it can improve the investment decisions the firm will face in the future. When there is asymmetric information between the managers of a firm and its shareholders, hedging may also affect the ability of shareholders to evaluate the quality of the management.
We end the chapter by taking a look at the practice of hedging. As a case study, we examine the logic behind Merck's decision to hedge its foreign exchange risk with foreign currency options. Merck's logic matches well with how Ford describes its risk management style.
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