Handout6B - Corporate Risk Management Q: What sort of risks...

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Corporate Risk Management Q: What sort of risks should a firm hedge? Should the firm hedge fully or partially? The pricing of derivatives and design of hedging strategies rely on the “principle of no arbitrage”. The same principle implies that there is no reason for the firm to engage in hedging activities in the MM (Modigliani--Miller) world (See 2A). In the MM world, “homemade hedging” is a perfect substitute for “Corporate hedging”. Corporate Finance © Professor Ho-Mou Wu 6B-1 Spring 2004
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Assumptions of Froot, Scharstein and Stein (FSS, 1993): (1).Market Imperfections: external funds are more expensive than internal funds of the firm. (2).The marginal costs of external funds increase with the amount raised. (3).There are diminishing marginal returns to investment (or output is a concave function of investment). (4).Hedging to smooth out a target fund does not affect its expected level. Corporate Finance
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Handout6B - Corporate Risk Management Q: What sort of risks...

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