“The globalization of firms and capital markets meant that an increasing number of firms have to make decisions about hedging their foreign exchange exposure.”(Alburquerque, 2007).
‘‘We expect net income per common share growth in the range of 10 to 15 percent in each of the next five years, excluding foreign currency translation.''(Mike Quinlan, Chairman and Chief executive officer, McDonalds, 1997 edition of The Annual)
By Crabb 2002
The above quotation was a warning to McDonald investors about the potential impact of fluctuations in currency exchange rates on the company's profits. The volatility of the exchange rate since 1975 can be viewed in the appendix.In spite of this warning, empirical studies of exchange rate movements and stock returns have shown that fluctuations in exchange rates have no significant impact on the return to investors for most corporations, especially for large multinationals such as Mobil and McDonalds (Crabb, 2002). Empirical studies have shown that currency hedging reduces the risk of a firm, However “reduction of risk is not the same as adding value or return” (Eiteman et al, 2010). Despite this knowledge, many firms' still hedge their investments. Using the Shareholder Wealth Maximization Theorem, which assumes that the objective of every firm is to maximize shareholders' value (Pike and Neale, 2006), this essay will discuss how currency hedging might possibly increase shareholders' value
Currency hedging refers to “establishing an offsetting currency position so that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge”(Shapiro, 2010). This concept is adopted to minimize or eliminate foreign exchange exposure which can result from either overseas transactions (transaction exposure) or currency conversion in the balance sheet (translation exposure). (Silicon Valley Bank, 2008). Locking in the home currency will ensure that any loss or gain incurred as a result of these exposures will be offset by a corresponding gain or loss. This is in contrast to the philosophical goal of management. According to the shareholder wealth maximization model, management's objective should be to maximize shareholders' value which is measured by the sum of capital gains and dividends, given a certain level of risk (Eiteman, 2010). It is the same as maximizing the net present value of the firm.
Foreign exchange risk generally refers to level of exposure of a company to fluctuations in exchange rate. These exposures can be classified into four groups:
This arises for the purpose of reporting, consolidation and conversion of financial statements of foreign operations to the home currency involved. This is also known as accounting exposure. Companies like Dell, Chevron, Mobil, HSBC that have operation overseas, have to battle with the changes in exchange rate movement when trying to translate their accounts that are denominated in foreign currencies. Such changes may result in either losses or gains for a firm'. Translation can be measured using
This is a contractually binding future financial obligation which occurs prior to any changes in exchange rate but is not due for settlement until after the exchange rate changes. This exposure refers to the risk of making either losses or gains from settlement of existing financial obligation that is stated in foreign currency. The exposure begins from the minute the quotation is made to a potential buyer, until the seller receives payment. Any change in the exchange rate could either be favourable or unfavourable for either the seller or the buyer.
This is degree or level to which the present value of a firm is affected by unexpected future cash flows changes of a firm which is as a result of unexpected changes in exchange rate. The effect of such changes can be viewed from the future sales volume, prices and costs of the firm.
This is the combination of transaction and operating exposures
It is the responsibility of the financial manager to measure and manage the extent of exposure experienced by a firm so as to maximize profit, cash flow and market value. These elements help investors view the relative success or failure of a firm.
The sensitivity of expected cash flows to changes in exchange rates has put pressure on firms to manage their currency exposures through hedging (Eiteman, 2010 pg 282-284). According to the financial theory, all expected cash flows make up the net present value of a firm.
The graph above illustrates a distribution of expected net cash flows. If a firm hedges its expected cash flow, the variability of the cash flow is reduced, thereby creating a level of certainty. This reduces the risk exposure faced by shareholders'. However, no value is added to shareholders' return. Thus the expected value remains zero. For the value of the firm to increase, the mean of the distribution must be positively skewed and this shift must be large enough to compensate for the cost of hedging. This is illustrated in the graph below.
Corporate financing decisions cannot be used to increase firm value in efficient capital markets since shareholders can easily replicate them (Modigliani and Miller, 1958)”. In other words, a corporate financing policy is irrelevant if the fixed investment policy does not include taxes, agency costs or transaction costs. In their paper entitled ‘The cost of capital, corporation finance and the theory of investment', they demonstrated that, operations and real investment decisions solely determine the value of any firm. . However, their analysis is dependent on certain assumptions which if violated should increase shareholders' value (Barnes, 1998).
E(T) represents expected corporate tax liability witout hedging
E(T:H) represents corporate tax liability with a costless, perfect hedge
E(V) represents expected pre-tax value of the firm without hedging
E(V-T) represents post-tax firm value without hedging
E(V-T: H) represents post-tax firm value with a costless, perfect hegde
Vj(Vk) represents pre-tax of the firm without hedging if state j(k) occurs
C* represents maximum cost of hedging where is profitable.
Reduction in the variability of a firm's pre -tax value through costless hedging will lead to a drop in expected tax liability and a rise in expected post tax liability, as long as the cost of hedging is not too large.
The major objective of currency hedging is to reduce exchange rate exposure. Even with the attempts made by various theorists to contradict the belief of hedging as a non value adding tool, most of their findings have being inconclusive. This essay clearly proves that unless the assumptions ono taxes, transaction costs or asymmetric information are violated, hedging financial risk should not add value to the firm because shareholders' can undo any risk activities implemented by the firm at the same cost, which makes hedging irrelevant.
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