Chapter 17
Risk Management and the Foreign
Currency Hedging Decision
QUESTIONS
1. Why would an entrepreneur find it desirable to hedge his or her foreign exchange risk?
2. Explain Modigliani and Miller’s argument that hedging is irrelevant. What are the most likely
violations of Modigliani and Miller’s assumptions in actual markets?
Answer: Modigliani and Miller argued that a corporation’s financial policies, such as issuing debt,
hedging foreign exchange risk, and other purely financial risk management activities, do not change
the value of the firm’s assets unless these financial transactions lower the firm’s taxes, affect its
investment decisions, or can be done more cheaply than individual investors’ transactions can be
done. The reason that reducing the uncertainty of future cash flows, per se, does not lead to a
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11. Why is an internally generated cash flow of such importance to Merck? Can’t Merck use the
financial markets as a source of funds?
12. True or false: The cost or benefit of hedging foreign exchange risk when a firm is selling the
foreign currency forward is accurately measured by the forward discount or premium on the
foreign currency.
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PROBLEMS
1. Chapeau Rouge has a Swiss project that will return either CHF300 million or CHF250 million
per year of free cash flow indefinitely. Each of the possible CHF cash flows is equally likely.
Chapeau Rouge’s CHF discount rate for these cash flows is 13% per annum, the cost of the
project is €1,100 million, and the current exchange rate is CHF1.67/EUR. Should Chapeau
Rouge accept the project? Suppose that Chapeau Rouge has a €400 million line of credit with its
bank. Will Chapeau Rouge have trouble hedging the CHF cash flows?
Answer: We need to take the present value of the project in Swiss francs and then convert to euros at
the current spot rate. Since the project’s cash flow is a perpetuity with an expected value of CHF275
million per year, we know that the present value, when discounted at 13%, is
CHF275 million
Present value in Swiss francs = = CHF2,115.38 million
0.13
Converting this present value into euros at the current spot exchange rate of CHF1.67/EUR gives
CHF2,115 million / (CHF1.67/EUR) = €1,266.70 million. Since this exceeds the cost of the
investment of €1,100 million, Chapeau Rouge should accept the project.
If Chapeau wanted to hedge the cash flows, they would want to sell CHF275 million for euros in
each year out into the indefinite future. Their credit line of €400 million would not be adequate to
allow such a substantial exchange-rate exposure. Moreover, we know that the transactions costs of
entering into longer term forward contracts increase substantially, which would significantly increase
the cost of hedging if Chapeau Rouge contracts to sell more than a few years forward. Consequently,
Chapeau Rouge would continue to have a large exposure of the value of the project to a depreciation
of the Swiss franc relative to the euro.
2. Fleur de France has a project that will provide £20 million in revenue in 1 year. The project has
a euro cost of €30 million that will be paid in 1 year. The cost of the project is certain, but the
future spot exchange rate is not. Assume that there are only two possible future spot exchange
rates. Either the spot rate in 1 year will be €1.54/£ with 55% probability, or it will be €1.48/£
with 45% probability. Assume that the French tax rate on positive income is 45%, that a firm’s
losses are immediately refunded at a rate of 35%, and that the forward rate of euros per pound
equals the expected future spot rate.
a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value
of its after-tax income on the unhedged project?
b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of
its after-tax income on the hedged project?
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Answer: The expected future spot rate is the probability weighted average of the two possible
realizations: (0.55 × €1.54/£) + (0.45 × €1.48/£) = €1.513/£
c. How much does Fleur de France gain by hedging?
Answer: By hedging, Fleur de France shifts income from the good state of the world with pound
appreciation to the bad state of the world with pound depreciation. It also avoids the loss that is
3.
3. How would your answer to problem 2 change if instead of allowing refunds at 35%, the refund
rate were only 25%?
Answer: We know that the larger the difference between the tax rates, the larger the gain to hedging.
If the subsidy rate is only 25%, Fleur de France will experience an after-tax loss if it does not hedge
of €0.30 million with 45% probability because
4. How would your answer to problem 2 change if the possible exchange rates in the future were
€1.56/£ and €1.46/£?
a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value
of its after-tax income on the unhedged project?
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b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of
its after-tax income on the hedged project?
Answer: The expected future spot rate is the probability weighted average of the two possible
c. How much does Fleur de France gain by hedging?
5. Assume that U.S. Machine Tool has $50 million of debt outstanding that will mature next year.
It currently has cash flows that fluctuate with the dollar–pound exchange rate. Over the next
year, the possible exchange rates are $1.50/£ and $1.90/£, and each exchange rate is equally
likely. The company thinks that it will generate $30 million of cash flow from its U.S.
operations, and its expected pound cash flow is £12 million.
a. If U.S. Machine Tool does not hedge its foreign exchange risk, what will be the current
market value of its debt and equity, assuming, for simplicity, that the appropriate discount
rates are 0?
b. Suppose that U.S. Machine Tool has access to forward contracts at a price of $1.70/£. What
is the value of the firm’s debt and equity if it hedges its foreign exchange risk? Would the
shareholders want the management to hedge?
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c. Suppose U.S. Machine Tool could invest $1 million today in a project that returns £1 million
next period. Is this a good project for the firm?
d. Suppose that U.S. Machine Tool is unhedged, that its managers are trying to maximize the
value of the firm’s equity, and that the $1 million must be raised from current shareholders.
Will the managers accept the project?
e. If U.S. Machine Tool hedges its foreign exchange risk, would the firm accept the project?
Answer: Yes, if the firm is hedged, the debt is riskless and the equity is worth $0.4 million. The
6. Example 17.5 demonstrates that hedging is profitable for the Starpower Corporation.
Demonstrate that the benefit to hedging is less if Starpower is more profitable. Do this by
redoing Example 17.5 with possible exchange rates of $0.65/CHF and $0.45/CHF.
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If Starpower hedges by selling CHF40,000,000 forward at $0.55/$, it will pay taxes on the
$3,000,000 of sure income, giving it an after-tax income of
( )
$3,000,000 1 0.45 $1,650,000 − =
When Starpower hedges, it pays $1,350,000 of tax instead of the expected tax of $1,450,000 when it
does not hedge. Starpower therefore saves $100,000 of expected tax payments. In Example 17.5,
Starpower saved $300,000 of expected tax payments.
7. Go to the J.P. Morgan’s Best Practices: Foreign Exchange Risk Management,
https://www.chase.com/content/dam/chasecom/en/commercial-bank/documents/foreign-
exchange-risk-management.pdf. Do you agree or disagree with their approach? Can you
make suggestions for improving their approach?