Introduction and review of traditional theories

The international monetary system has been reformed several times during the last two centuries. Today, it is composed of national currencies, artificial currencies and one common currency, the Euro. With regards to exchange rate regimes, since the collapse of Bretton Woods Agreement, the floating exchange rate is largely adopted by most of the economies at a global level. Nevertheless, it should be clarified that only 80 out of the 186 countries are actually ‘floating' to any real extent and, although the contemporary international monetary system is perceived as a ‘floating regime' , this is not reflected to the majority of the world's economies (Eiteman, Stonehill and Moffett, 2010, p. 60). However, the impact of the application of the floating regime on the global economy has undoubtedly contributed to more volatile and unpredictable exchange rates and interest rates. Furthermore, due to the liberalization of trade, international investments have considerably increased, as firms may hold foreign assets or debt and conduct transactions in foreign currency. Therefore, a firm's value is significantly vulnerable to exchange rates fluctuations and volatility and FX risk management has become an issue of great importance. In order to eliminate this risk, financial managers apply various currency hedging techniques, the purpose of which is to provide ‘safety' in the present value of all expected future cash flows. The question is whether these hedging techniques actually add value in the shareholders' wealth or have zero effect on them.

Arguments which support the irrelevance of hedging techniques to the creation of firm's value are based on international parity conditions between currencies, commodity prices and interest rates, particularly the Purchasing Power Parity and International Fisher Effect. On the grounds that there is an equilibrium between the above factors, risk management does not have any impact on the value, provided that negative movements in one element are compensated directly by an offsetting event in another risk element. Nevertheless, according to recent empirical studies, these parity conditions exist at most in the long term (Alexius, 1996; Rhim, Khayum and Kim, 1996; Froot and Rogoff, 1994; Marston, 1994; Abuaf and Jorion, 1990; Adler and Lehmann, 1983). For shorter time periods there are significant deviations. An illustrative example of the above case is given by Rolls-Royce. This firm relied on PPP on its pricing decisions and consequently experienced substantial losses in 1979, originated from its direct exports to the United States. Inflation rates had risen at a higher level than expected in the United Kingdom than in U.S.A. and according to PPP, sterling should depreciate. Instead, sterling appreciated, leading to huge losses on both its dollar-dominated receivables and its expected revenues (Dufey & Srinivasulu, 1983). However, this assumption does not indicate who should be charged with such decisions, corporations or shareholders. At this point, the irrelevance theorem by Modigliani and Miller (1958) may be utilized. According to this, a firm's value is not affected by its financial policy and capital structure, under a certain set of adequate conditions. These conditions are:

Ø There are no transaction costs

Ø There are no taxes

Ø There is no cost of financial distress

Ø There are complete capital markets without information asymmetries

Ø Investors and firms have equal access to financial markets

Consequently, the managers are unable to increase the firm's value by conducting financial transactions, which can be applied by shareholders as well (Sercu and Uppal, 1995).

However, the economies are not as ideal as Modigliani and Miller suggest. Capital markets are characterized by imperfections, such as transaction cost, financial distress and taxes and corporate risk management needs to be assessed in terms of whether and to what extent it contributes to its goal by raising shareholders' value, given the realistic market imperfections. In order to meet this need, several positive theories have been developed and argue that currency hedging at a firm level may be used as a means to increase shareholders' value, as it is explained later in this paper.

But before presenting these theories, an issue which should be clarified is the confusion between the ability of hedging to reduce risk and its potential to enhance value. As it is shown at the figure below, currency hedging limits the cash flows around the mean of the distribution, which is actually translated into reduction of risk. But, this decrease should not be confused with value addition, which takes place only if the mean of the distribution moves to the right. Provided that hedging activities imply cost, hedging will add value to the firm only if the rightward shift covers the hedging costs.

Positive Risk Management theories

The arguments in this paper are based on the work of Bartam, S. (2000) and Aretz et al. (2009). In particular, there are three major factors which contribute to the increase of shareholders' value, owing to currency hedging.

1. Agency costs

1.1 Underinvestment

According to agency theory, certain conflicts of interests are observed between shareholders on the one hand and managers and debt-holders on the other. These conflicts are likely to be more intense in firms with high financial leverage and volatile value. Although managers are requested to accept projects with a positive NPV, it is possible that they are unable to identify all the profitable projects , due to the existence of high leverage (underinvestment problem) (Myers, 1977). This happens, because the firm's value is volatile and any produced value should be utilized to satisfy debt-holders first. Consequently, shareholders would have incentives to reject some positive NPV projects.

Hedging techniques, however, may eliminate these conflicts of interest by reducing the volatility of a firm value and thus making it less likely that firm value reduces to levels at which there are incentives for shareholders to give up positive NPV projects (Smith, 1995; Bessembinder, 1991). In other words, hedging, may increase firm's value by reducing incentives to under-invest.

1.2 Divergent Risk preferences >

Another example of agency cost originates from the conflict between managers and shareholders in terms of risk preferences. Managers are likely to consider their personal preferences towards risk when they are called to choose the firm's level of risk, which might differ from shareholders' preferences (Smith and Stulz, 1985), resulting in failure to meet the target of shareholders' wealth maximization. In this case, agency costs appear through shareholders' efforts to eliminate this behavior by close monitoring (Mayers and Smith, 1982). Hedging can reduce these costs, since it lowers the risk of profitable growth potentials and integrates the risk aversion of undiversified managers (Stulz, 2002).

2. Transaction costs

2.1 Costs of financial distress

Transaction costs of financial distress due to the lack of liquidity are observed in cases where a firm cannot meet fully its fixed payment obligations (e.g. wages, interest on debt) (Myers, 1977). One of the possible outcomes of this hurdle is that the firm may face the threat of bankruptcy. In practice and in contrast with M&M theorem, financial distress does exist and hedging technique can be used, in order to reduce the probability of such a case, as firms are more likely to experience financial distress if they have high fixed payment obligations and volatile cash flows. Particularly, Mayers and Smith (1982), suggest that hedging can decrease the possibility of financial distress by reducing the variability of firm's value, and then minimizing the expected cost of financial distress and thus increase the value of the firm.

2.2 Cost of hedging

Hedging techniques imply cost for the firm, which should be compensated with equal benefits to the shareholders. However, it has been estimated that the economic cost of hedging is insignificant even under the imperfect capital market hypothesis (Fite and Pfleiderer, 1995, p.144). The beneficial effect of hedging, though, is highly contingent on the extent to which the risk management is performed using in-depth knowledge of the size and the structure of the financial exposure. Given the fact that firms are reluctant to disclose the adequate information to estimate this exposure, information asymmetries between management and investors exist. Therefore, hedging is likely to be performed significantly more efficiently at the firm level and enhance their shareholders' value (Sercu and Uppal, 1995, p. 458).

3. Taxes

Another unrealistic condition of M&M theorem is the non-existence of taxes. In practice, firms' revenues are taxable and treated in accordance with each economy's tax system. If the firm's revenues are subject to a convex tax code, i.e. if taxes increase more than proportionally with taxable income, volatile pre-tax income contributes to a higher tax burden than stable pre-tax income. Therefore, in cases where corporate hedging stabilizes the taxable income, it enhances value, on the grounds that savings from higher income states surpass additional taxes from lower income states, consequently reducing the average corporate tax burden (Smith and Stulz, 1985).


All things considered, in the presence of market imperfections, without the shadow of a doubt currency hedging can offer a very useful tool for managing corporate risk and has the potential to produce a positive impact on a firm's value, provided that it is structured and implemented appropriately.

All things considered, in the presence of market imperfections, without the shadow of a doubt currency hedging can offer a very useful tool for managing corporate risk and has the potential to produce a positive impact on a firm's value, provided that it is structured and implemented appropriately.

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