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Why Hedge?

Why Hedge?. Objective. Discuss the pros and cons of hedging. Outline. Discussion Exemplification. Lack of consensus. In the financial world there is no consensus on whether a firm should hedge. Arguments Hedging is costly Hedging exchange risk exposure is redundant

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Why Hedge?

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  1. Why Hedge?

  2. Objective • Discuss the pros and cons of hedging

  3. Outline • Discussion • Exemplification

  4. Lack of consensus • In the financial world there is no consensus on whether a firm should hedge. • Arguments • Hedging is costly • Hedging exchange risk exposure is redundant • - Stockholders can do their own home-made hedging (similar argument to M&M leverage irrelevance theory). • There are companies that choose not to hedge their currency exposure.

  5. The case for hedging: Market imperfections • Information asymmetry • Managers have better information about firm's risk position • Economies of scale & easy access • Managers are in a position to acquire low-cost hedges • Cost of bankruptcy • When default costs are significant, hedging may reduce those costs, hence improving the credit rating of the company (risk position shift) • Tax argument • Under progressive corporate tax rates, firms pay more taxes in high earning periods than it saves in low earning periods. • The lower the variance of profits, the lower the average tax liability (tax advantage)

  6. Tax argument illustrated Consider the following tax rates:

  7. Consider two companies with identical expected cash flows, but with different level of risk

  8. Conclusion 1 • Hedging reduces the tax bill

  9. Consider two companies with different expected cash flows, and with different level of risk

  10. Conclusion 2 • Hedging reduces the tax bill

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