Finance Essay

1317 words - 5 pages

INTRODUCTION

The purpose of this paper is to examine if “Currency Hedging at firm level adds share-holder values”. A lot of papers have been written based on this sentence and there are many opinions that have been vented through of these researches. In a perfect world, according to Modigliani and Miller theorem, there is no reason to hedge because hedging does not add value to the firm. So, when there is not asymmetric information, taxes and transaction cost risk management is irrelevant to firms. On the other hand, we have a number of studies that support that the currency hedging is positively related to the increase of shareholder value. Allayannis and Weston (2001) using U.S. data from 720 firms found that hedging boost firm value, while same results had the researches of Stulz (1984), Frood, Scharfstein and Stein (1993), Nance, Smith and Smithson (1993), Tufano (1996) and Geczy, Minton and Schrand (1997).

The Role of Hedging

In the real world that we live, hedging have an effect on the share-holder values because it can affect the volatility of cash flows. Hedging is a position that we take in one market so that offset another position that we have in another market. Currency hedging, especially, is the way to minimize the risk of foreign investment exposures of one firm compensating any changes in foreign exchange values. Doing it, we eliminate any gain from an increase in the value of the asset hedged against. The reason that a firm want to hedge is that it wants to reduce the volatility of future cash flows (FCF). During the time, FCF can alter from changes in exchange rates, reducing or increasing the values of cash flows and it is harmful for the firm. So, currency hedging reduces risk, helping the firm to plan its future investment, not to fall below of its minimum deposit cash and to know the actual currency risk of the firm.

Types of Foreign Currency Derivatives and Foreign Exchange Exposures

The most important mission of a manager is to evaluate and to control the foreign exchange exposure so that to maximize the profitability, cash flows and market value of the firm.

In order to achieve it, managers use foreign currency derivatives. The main three common derivatives are foreign currency forwards, futures and options.
Foreign currency forwards are traded over the counter and involve a forward contract and funds to complete that contract. Foreign currency futures are traded on organized exchanges and they give the obligation to the holder to make a delivery of a standard amount of foreign exchange at fixed time, place and price. Foreign currency option is a contract that gives the holder the right, but not the obligation, to buy or sell an amount of foreign exchange for a fixed price per unit until the maturity date.

Using these foreign currency derivatives managers try to deal with the three kinds of FX exposure: a) transaction exposure that measures profits or losses that arise from transactions in...

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