Consider the impact of a permanent 5% appreciation of the US$, holding all other factors constant. The slope measures the exposure of the firm at the initial exchange rate.
Empirical Evidence on Firm Profits, Share Prices, & Exchange Rates • During the Bretton Woods pegged-rate period, the general stock market index tended to move up (down) immediately after a devaluation (revaluation) of the local currency. • Studies also indicated that exposure coefficients vary from firm to firm within the same industry and over time, and that exchange rate changes can have a substantial impact on the overall economy.
Arguments for Hedging Risks at the Corporate Level • Shareholders may not favor hedging since they can select well-diversified portfolios to rid themselves of firm-specific risks. • However, in view of transaction costs and taxes, hedging that reduces the volatility of cash flows may be favoured. • If the tax credits of a firm which has incurred losses over several successive periods cannot be carried forward to reduce future tax payments, then another firm with a less volatile pattern of earnings will enjoy greater after-tax cash flows and a higher market value. • A firm with more volatile cash flows is also more open to the costs of financial distress. • For the same reasons, banks and bondholders will prefer firms with less volatile cash flows (holding average cash flows equal) and reward them with greater borrowing capacities and higher credit ratings.
Financial Strategies Toward Risk Management • An important step in the process of determining the appropriate financial hedging instruments for a firm is to analyze the nature of the firm’s currency cash flows .
Financial Strategies Toward Risk Management Characteristics of Currency Exposure Suitable Financial Hedging Instruments Frequency of cash flows Single period Multiple periods Single contract (futures/options) Sets (“strips”) of contracts/swaps or present value hedge Currency dimension Single currency Multiple currencies Contracts on one currency Contracts on an index (ECU, US$) or synthetic hedge
Financial Strategies Toward Risk Management Characteristics of Currency Exposure Suitable Financial Hedging Instruments Certainty about cash flows Certain, contractual cash flows Uncertain, estimated cash flows Naïve hedge to match contract size of financial instrument and exposure Option hedge or dynamic futures hedge to match probability of cash flows
Financial Strategies Toward Risk Management • Note that a hedging strategy may offset certain risks, while leaving open or increasing other risks .
Policy Issues International Financial Managers • Problems in Estimating Economic Exposure • Using market data presumes that financial markets are efficient, and that share prices respond quickly and appropriately to exchange rate changes.
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