Currency Hedging

6 Pages   |   1,348 Words
Currency Hedging at Firms Level Adds Shareholder Values

Hedging currency is a method that is used by the professionals to reduce the degree of risk that they face when they engage their self in some kind of foreign investment. Mainly the hedging includes compensating any type of shifts in the related currency from its original value which investor is interested in to invest. By doing so investor tries to minimize its risk even if the currency that he invested in deviated from its original value, investor does not take a hit thereby minimizing the losses. Hedging provides investor with a shield that prevents its investment from tasking s fall. The idea behind hedging is to exchange currency when the rates are in you favor and then make the investment in the respective country wroth its local currency. . For example, rather than paying for shares of stock connected to a company based in the United Kingdom with United States dollars, the investor would first convert the dollars into British pounds, then use the pounds to make the actual stock purchase.

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It Is not mandatory that currency hedging will add value to shareholder as there is no surety that the hedge would be a perfect hedge, Therefore in perfect markets there is no point saying that currency hedging would add value to the shareholder as the exchange rates are determined by the demand & supply and the shareholders can undo the hedging at any moment in time. Whereas in imperfect market which exists in the real world, the currency hedging at firms level will add value to the shareholders. This is because it can protect them from occurring losses though it doesn’t assure them of any guaranteed profit. Although, the incentive they get from currency hedging is the minimization of risk of loss though they can’t totally eliminate it as perfect hedge is not possible. This had been a great topic of debate among the researcher some believe that currency hedging at firms levels adds shareholders value whereas other oppose  it strictly. According to Modigilani and Miller (1958) in the perfect capital market hedging policies adopted by a particular firm does not affect its shareholders value because they can change their hedging policy any time they want. But according to the recent researches conducted, capital markets are declared as imperfect so as a result hedging can increase over all firms value by favorably changes its investment, expected finical costs and taxes. Recently researchers depicted the value of hedging to derive a firm’s value. For example Allayannis & Weston (2001) finds in their research that in large sample of firms that the firms that hedge have 4.87% higher value than the firms that chooses not to. Guay and Kothari (2003) do not agree with that particular research and challenges that hypothesis and its result. According to them the changes occur due to hedging rare of minimal nature and cannot bring about large changes in a particular firm and according to them the statistics shown in Allayannis and Weston (2001) is largely driven by other risk minimization activities such as operational hedges. Another bunch of researchers Jin and Jorion (2006) find no particular reason to link hedging with the increased firm value that is due to the reason that the increasing firm’s value encourages firms to hedge rather than hedging increased firm value because the past data of the firm related to hedging generally not consistent. The system generalized method of moments (GMM) estimator developed by Arellano and Bover (1995) and Blundell and Bond (1998) can estimate the effect of hedging on firm value in a dynamic panel framework. I believe that the effect of foreign currency hedging on firms value as previously measured by Tobin’s Q, for a sample of 408 large U.S. nonfinancial firms with foreign sales from operations abroad over the period 1996 to 2000 is a significant to prove that the currency hedging at firms level adds shareholder values. In that particular period dollar appreciate against foreign currencies of U.S trading partners so if firms have long position in the future they can derive he benefits from hedging. According to the statistics foreign currency hedging increases firm value by 6.33% when foreign currency hedging is assumed to be strictly exogenous. These particular results also hold for the firms with higher foreign currency risks but the evidence found were not great for the firms with higher values with greater possibility of finical distress. The main theme of this article is to show that foreign currency hedging is not strictly exogenous and after controlling the factors hedging has no affect firm value.

Theories relating to the hedging based on the capital market imperfections suggest that hedging can increase shareholders value. For example Smith and Stulz (1985) said that a firms tax system conveys means it can minimize expected tax liability by reducing the volatility of its taxable income. They also argues that the financial distress is of great cost and hurt the firm finically so hedging can help protect the value of the company by minimizing the financial distress. Froot, Scharfstein and Stein (1993) argues that with unexpected cash flows and costly external finance over period of time hedging is a good tool to ensure that firm have enough internal fiancés to grab a external opportunities. Another researcher Leland (1998) said in his research that hedging will increase a particular firm’s debt. For example, Knopf, Nam and Thornton (2002) find a positive relation between hedging and managerial share ownership, which is consistent with the managerial risk aversion argument capacity and therefore increase  a firms value due to the tax payments that is been deducted .

In their research Carter, Rogers and Simkins (2006) found out that U.S airlines companies saved money by fuel hedging as a result increasing their firm value 5-10 %.Mackay and Moeller (2007) control for the potential endogeneity of hedging with respect to firm value and find that hedging concave revenues and leaving concave costs exposed increases firm value by 2%-3% for a sample of U.S. oil refiners. Guay and Kothari (2003), on the other hand, find that the potential gains on hedging portfolios are small when compared to cash flows and firm size and are unlikely to generate large changes in firm value. Jin and Jorion (2006) also find that hedging does not affect firm value for a sample of U.S. oil and gas producers which is of a surprise. Given that the estimated increase in firm value documented in previous studies could be biased and inconsistent if hedging is not strictly exogenous, it is important to re-examine the question of whether hedging affects firm value after controlling for the possibility of feedback from past amounts of firm’s value to the current amount of hedging.

After taking the research that has been done taking in to account we clearly see that hedging clearly provide a cover for the investors on different circumstances and help improving the business as well moreover hedging benefits can be different for different industries the industry with more foreign risk involve hedge more often than the one that do not expose to it. Some companies hedge more often than others due to the financial benefits that they drive from it that is already been discussed with the examples so over the past decades hedging do drive huge benefits for the companies and their share holders.


Carter, D.A., Rogers, D.A., Simkins, B.J., 2006. Does hedging affect firm value?
Guay, W., Kothari, S.P., 2003. How much do firms hedge with derivatives? Journal of Financial Economics 70, 423-461
Jin, Y., Jorion, P., 2006. Firm value and hedging: Evidence from U.S. oil and gas producers. Journal of Finance 61, 893-919
Smith, C.W., Stulz, R.M., 1985. The determinants of firms' hedging policies. Journal of Financial and Quantitative Analysis 20, 391-405
Allayannis, G., Weston, J.P., 2001. The use of foreign currency derivatives and firm market value. Review of Financial Studies 14, 243-276
Knopf, J.D., Nam, J., Thornton, J.H., 2002. The volatility and price sensitivities of managerial stock option portfolios and corporate hedging. Journal of Finance 57,801-813

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