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Multinational Finance, 6th Edition by Kirt C. Butler

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Appendix 8A

The Rationale for Hedging Currency Risk

Why should the multinational corporation bother to hedge its exposures to currency risk? On the surface, the answer seems obvious. Hedging creates value by reducing the risk of assets exposed to currency fluctuations. However, the conditions under which hedging can add value are not as obvious as one might think. What if currency risk is entirely unsystematic and diversifiable, and therefore does not matter to investors? In this case, hedging can reduce cash flow variability, but cannot change investors' required returns or the corporation's cost of capital. Where, then, is the value in hedging?

Firm value can be viewed as the present value of expected future cash flows discounted at a rate that reflects the systematic risk of those cash flows.

If hedging is to add value to the firm, then it must affect cash flows or the cost of capital in a way that cannot be replicated by investors. The issue of whether currency risk affects the discount rate is discussed in the chapter on international asset pricing. This appendix shows how hedging exposure to currency risk can increase expected cash flows in the numerator of Equation (8A.1).

Hedging can add value to the firm when market imperfections make it costly or impossible for individual investors to capture the same benefits from hedging as the firm can capture. The most important ...

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