The Case for Corporate Management of Foreign Exchange Risk

Author(s): Gunter Dufey and S. L. Srinivasulu

Source: Financial Management, Vol. 12, No. 4 (Winter, 1983), pp. 54-62
Published by: Wiley on behalf of the Financial Management Association International
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 The Case for Corporate Management of
Foreign Exchange Risk

Gunter Dufey and S. L. Srinivasulu

Professors Gunter Dufey and S. L. Srinivasulu teach at the Graduate

School of Business Administration, The University of Michigan, and
at the College of Business, Eastern Michigan University, respectively.

* The objective of this paper is to present the case forthat whatever the firm can do, investors can do; hence,
corporate management of foreign exchange risk. The even if exchange risk needs to be hedged, it need not be
arguments that oppose hedging at the level of the firm hedged by the firm.
can be summed up as follows: 4. The concept of self-insurance implies that -
Foreign exchange risk does not exist; even if it ex- since the effects of exchange rate changes average out
over time - no effort need be made to manage ex-
ists, it need not be hedged; even if it is to be hedged,
corporations need not hedge it. change risk. Similarly, if foreign exchange markets are
In support of the above reasoning, one or more of efficient, forward contracts are appropriately priced
the following arguments are advanced. and, as a consequence, nothing is gained by hedging.
1. The Purchasing Power Parity (PPP) theorem im- 5. Exchange-related gains and losses may be useful
plies compensating changes in price levels and ex- for hedging risks associated with the consumption bun-
change rates; hence, there is no exchange risk. dle; thus, exchange-related fluctuations are desirable
2. The Capital Asset Pricing Model (CAPM) pur- for investors, and corporations should not hedge them.
portedly suggests that it makes no difference whether 6. As both future forward rates and future spot rates
exchange risk is managed separately or passed along toare uncertain, hedging is of dubious value and does not
reduce
the capital market; hence, even if exchange risk exists, uncertainty.
it need not be hedged. While some of these themes (summarized in Exhibit
3. The Modigliani-Miller (MM) theorem implies have been reviewed previously [17, pp. 8-10; 11,
I)
pp. 82-83; 9, pp. 2-4], they will be discussed in a
The authors appreciate the constructive comments of two logical sequence, and a case will be made for corporate
anonymous
reviewers. management of foreign exchange risk.
54

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DUFEY, SRINIVASULU/CORPORATE MANAGEMENT OF FOREIGN EXCHANGE RISK 55

Exhibit 1. Arguments Against and For Corporate Management of Foreign Exchange Risk: Summary
Against For Against For
1. I. Deviations
Purchasing from PPP have
Power Parity
4. The Concept of Self-Insur- 4. This concept implies maxi-
Theorem: been well
PPP documented; the
implies off- ance: The forward market mizing expected value
shorter the time
setting changes in horizon,
price is a fair bet and does not without regard to variance,
levels and exchange rates;
the greater the deviations. provide bargains. The for- and thus assumes risk neu-
hence, thereEvenis
if PPP
noholds with re-
exposure eign exchange gains and trality. However, econom-
to exchangespect
risk.
to an index of trade- losses average out over a ic agents are usually risk-
able goods, a particular period. averse.

firm may still be exposed The Efficient Market The objective of hedging is
to exchange risk, since the Hypothesis: Since the for- not to earn excess returns,
relative price of its inputs eign exchange markets are but to achieve a desired
and outputs may change. efficient, forward con- pattern of risk and return.
2. Capital Asset Pricing 2. When default risk is im- tracts are priced properly
and there are no excess re-
Model (CAPM): Accord- portant, hedging can re-
ing to CAPM, what mat- duce default risk and add to turns from hedging.
ters is only one systematic the debt capacity of the 5. Hedging of Consumption 5. As the consumption bundle
risk; it does not matter firm. Bundle: A firm's ex- is investor-specific, its
whether exchange risk is change-related gains and management is better left
managed separately in for- losses may be usefultoto the shareholder. Firms
eign exchange markets, or hedge the consumption should hedge exchange
passed along to the capital bundles of its sharehold- risk and the shareholder
market. ers. should hedge consumption
bundle risk.
3. Modigliani-Miller (MM) 3. There are several obstacles
Theorem: According to to individuals in coping 6. Hedging makes available
6. The Uncertainty of For-
MM, what the firm does, better with exchange risk. ward Rates and Spot exact information regard-
an investor can do; hence, A firm is in a position to Rates: Since future for- ing anticipated cash flows;
there is no need for corpo- obtain a low-cost hedge; ward rates are as uncertain such information can be
rate management of ex- also information on the useful for activities for
as future spot rates, hedg-
change risk. firm's exposure is not sym- ing is of dubious value. which the planning and ac-
metrically distributed be- tion horizon is the same as
tween shareholders and
the maturity of the forward
managers. contract.

1. The Purchasing Power Parity (PPP) or the French exporter of wine is nonexistent because
Theorem and Similar Parity Conditions the change in nominal prices in the respective national
There is a burgeoning volume of literature on Pur- currencies has been compensated for by the exchange
chasing Power Parity and this is not the place to review rate change.
this material (for a review refer to [18]). Instead, dis-
Unfortunately, there are many "ifs" and "buts"
cussion shall be limited to the relationship between that this highly simplified explanation of PPP does not
PPP and corporate management of foreign exchange take into account. First, all empirical tests have con-
risk. firmed that the adjustment between changes in prices
According to PPP, exchange rate changes offset and exchange rates is not instantaneous and that there
price level changes; hence, some argue, there is no are lags in this relationship: the longer the time hori-
exposure to exchange risk. For example, if the annual zon, the greater the empirical validity of PPP. For
rate of inflation in France is 10 percent higher than that shorter time periods, however, there are substantial
in the United States, the French franc will depreciate deviations. So if a firm's planning horizon is shorter
vis-a-vis the U.S. dollar by a corresponding percent- than that required for PPP to hold, the firm is exposed
age; as a result, there is no relative price risk. If one to exchange risk.
unit of American wheat exchanged for two units of Second, even assuming that PPP holds in the aggre-
French wine at the beginning of the year, that same gate with respect to the price level indexes (the weight-
exchange ratio will hold at the end of the year. The ed average prices) of two countries, it need not (and
mere fact that the franc has depreciated need not cause usually does not) hold for every commodity. Thus, the
concern. The effect on the American exporter of wheat "law of one price" (LOP) does not hold. If the in-

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56 FINANCIAL MANAGEMENT/WINTER 1983

creases in the price levels of wheat in the U.S.sterling.

and The large civil engines which Rolls-Royce
produces
wine in France do not correspond to the increases in the are supplied to American air frames. Be-
cause
inflation levels in their respective countries, there willof U.S. dominance in civil aviation, both as
be a relative price risk. Even if PPP and LOP hold,
producer and customer, these engines are usually
priced in U.S. dollars and escalated according to
prices of a firm's specific inputs and outputs might
American indices .... Inflation rates have risen at
change relative to each other, and thus expose the firm
to risk, which - if caused by unexpected exchange a higher pace than was expected and more sharply in
rate changes - must be viewed as exchange risk. theA United Kingdom than in the U.S.A. Far from
clarifying analysis that separates inflation and ex-
reflecting the differential rates of inflation the pound
change risk can be found in Cornell [4] and Shapiro appreciated against the U.S. dollar. [20, p. 4]
[22].
The fact that there are deviations from PPP - at PPP would predict that, since the inflation rate in
least for some periods - and that there are relative Britain was higher than that in the United States, ster-
ling should depreciate. Instead, sterling appreciated,
price risks for at least some goods implies the presence
of exchange risk. Rather than present the numerical causing Rolls losses on both its dollar-denominated
estimates of the extent of deviations from various em- receivables and its expected sales revenues. But even if
pirical studies, we will quote below the conclusions of sterling had depreciated as predicted by PPP, there is
one major work in this field: no guarantee that the extent of depreciation would have
been adequate to offset exactly the rate of inflation
Students exposed to the pure theory of international relevant for Rolls. The cost of producing jet engines in
trade have been seduced by visions of an imaginary the United Kingdom might have risen at a rate different
world .... In reality, the law of one price is fla- from that of British inflation in general.
grantly and systematically violated by empirical Rather than relying on PPP, a firm should plan to
data .... Exchange rate changes substantially alter cope with deviations from PPP. There are several ac-
the relative . . . prices of most . . .domestic and tions a firm can take to cushion the impact of such
foreign manufactured goods .... Moreover, these deviations. To protect operating cashflow over the
relative price effects seem to persist for at least sev- short term, forward sales of dollars or dollar debt can
eral years and cannot be shrugged off as transitory. be used. As a long-term measure, appropriate oper-
[10, p. 942] ational strategies may be advisable [23]. Thus, Rolls-
Royce may consider putting part of its operating ex-
To be sure, other studies draw somewhat different penses on a U.S. dollar basis through extensive
conclusions. But they all agree about one fact: there sourcing of components or by moving production par-
are deviations; they differ only in degree. tially to the United States. The fine tuning of these
policies requires further analysis, but our objective
Implications for Corporate Policy here is simply to show that belief in PPP is not an
Can a corporation rely on the broad macroeconomic excuse for not managing foreign exchange risk.
relationship of PPP and abdicate its responsibility to
manage exposure? The experience of Rolls-Royce in
1979 confirms otherwise. As shown below, this firm 2. The Capital Asset Pricing Model
relied on PPP in its planning and pricing decisions, and (CAPM)
as a result suffered huge losses. The implications of CAPM for corporate hedging
Rolls-Royce, the British jet-engine producer, relies decisions have been given extensive treatment by
on international markets for the sale of its products. In Logue and Oldfield [13] and Lessard [12, pp. 352-
1979, the value of its direct exports from the United 356]. According to CAPM, the essential factor that
Kingdom was on the order of ?348 million, which matters is the systematic risk. If exchange risk is un-
constituted 41 percent of its total sales of ?848 million. systematic, it can be diversified away by the investors
The proportion of its exports in earlier years had been in the process of constructing their portfolios. On the
about the same. In 1979, the firm had a loss of ?58 other hand, if exchange risk is systematic and if for-
million. Why? As its annual report poignantly records: ward exchange contracts are priced according to
CAPM, all that a firm does by entering into these
... the most important [influence] was the effect of contracts is to move along the Security Market Line;
the continued weakness of the U.S. dollar against that is. there is no addition to the value of the firm. As

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DUFEY, SRINIVASULU/CORPORATE MANAGEMENT OF FOREIGN EXCHANGE RISK
one author put it succinctly, "In the absence of imper-
fections like transactions costs and default risks, the
value of a forward contract would be zero at the instant
at which it was initiated" [1, p. 90].
However, among other objectives, the concern of
corporate management about total variability is moti-
vated by the need to avoid the cost of financial distress.
Thus, greater variability of net cashflow implies a
higher probability of bankruptcy and this, in turn, af-
fects the firm's cost of funds and its ability to raise
them. To quote some of the pertinent views from the
literature:
. . .costs of capital in the short run can be influ-
enced by the perceived riskiness of claims on multi-
nationals and that perceived riskiness, relative to
other multinationals, could be altered in the short
run by heavy exposure in foreign currencies. [14, p.
521]
. . .creditors may be concerned with total variabil-
ity of cash flows where default is possible. The
realized yet unanticipated capital gains and losses
that a firm experiences due to random currency fluc-
tuations may influence valuation through the effect
on debt capacity. Where total variability is impor-
tant, hedging in the foreign exchange markets may
add to the firm's debt capacity. [13, p. 21]
A third author argues that avoiding default seems to
be the most justifiable of all the possible goals that a
treasurer could have for hedging:
On the dimension of default risk, stockholders' and
management's interests largely coincide. Stock-
holders are averse to bankruptcy risk on the grounds
that the associated costs can permanently deplete
their equity. When the market perceives a rise in
default risk, share prices drop. Managers prefer to
reduce the probability of default or of cash inade-
quacy so as to avoid abdicating control in favor of
creditors. Jobs may then also be in jeopardy. Large
exchange losses can affect the adequacy of reference
currency cash flows. Consequently, bankruptcy-
risk reduction can partly be achieved by a policy of
hedging. [1, p. 91]
In summary, the desire to avoid default risk justifies
minimizing variations in cash flows through hedging.
3. The Modigliani-Miller (MM) Theorem
By extending the original argument of the MM theo-
rem to the international arena, it has been contended
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57
that corporate foreign exchange management is super-
fluous; what the firm does, an investor can do. In other
words, every investor is a potential foreign exchange
hedger.
In the domestic version of the MM theorem, a share-
holder can obtain "homemade leverage" by borrow-
ing for his own account; thus, the corporate borrowing
decision is irrelevant. In the extended international
version, it is argued that a shareholder can obtain
"homemade hedging" by hedging for his own ac-
count; again, the corporate hedging decision is irrele-
vant. Indeed, Feiger and Jacquillat [7] provide a for-
mal proof of the MM theorem as applied to the forward
currency positions of firms.
However, if for any reason hedging by investors is
not as efficient as corporate hedging, then it will be in
the interest of the shareholders to let the firm manage
the exchange risk. Below, several obstacles to investor
hedging will be examined.
a. Entry Barriers
There are two types of entry barriers: (1) size bar-
riers and (2) structural barriers. Size barriers are
caused by the fact that certain markets impose mini-
mum size requirements for transactions of goods and
services, whereas structural barriers are the result of
the way different economic entities can structure their
activities. These are described in turn below.
Size Barriers
The principal hedging instruments are forward mar-
kets, currency option markets, Eurocurrency markets
and foreign money markets. The bank-based forward-
option-, and the Eurocurrency markets are wholesale
in nature and deal in minimum amounts that tend to be
too large for individual investors. Further, banks tend
to limit access to forward and currency option markets
to customers engaged in foreign trade or those who
have foreign subsidiaries.
It is true that markets for currency futures, such as
the IMM in Chicago, offer an alternative to the for-
ward market that is readily accessible to individual
investors. However, both the size of the contract and
the delivery date are standardized in futures markets.
Further, prices can fluctuate without limit in the for-
ward market, but daily limits are imposed on ex-
changes in the futures market. Thus, the futures market
is less flexible. In addition, a security deposit is re-
quired to operate in the futures market. In the forward
market, banks may insist on compensating balances.
But while such balances are typically maintained by
firms in the course of their ongoing business activities,
58 FINANCIAL MANAGEMENT/WINTER 1983

tent It
they represent an additional cost for the individual. with
is public policy, while financial arbitrage does
not.
true that markets for risk instruments are becoming
better developed and more accessible. Since In
early
addition, specific subsidies are available to hedg-
1983, for example, currency option contracts in
ersmajor
in some countries. These take the form of special
currencies have been traded at the Philadelphia ex-
credit facilities, subsidized exchange risk insurance, or
specialtoforward rates ("swap facilities") offered by
change. However, some of the difficulties that apply
the-Central
currency futures pertain also to option contracts in Bank. Only firms can take advantage of
addition to the problems posed by the "thinness"these
andsubsidies for hedging purposes; they are not
available to individual shareholders.
uncertainties that characterize any immature market.
Hedging can be accomplished either by forward
contracts or by foreign currency borrowing and b. lend-
Information Gaps
ing. The former is known as a forward market hedge
In order to plan and achieve efficient diversification,
and the latter as a money market hedge. Hence,the obsta-
individual investor needs to know the level and
cles to individuals in foreign money markets are also,
timing of foreign exchange exposure for all the compa-
in essence, obstacles to investor hedging. In many
nies in the portfolio. Such information is required not
foreign money markets, nonresidents are denied ac-
only for today but for every future date.
cess to local borrowing facilities, or they may face
To calculate the exposure of the firm, investors need
discriminatory taxes. A local subsidiary of a multina-
detailed information not only on the operations side
tional corporation, being a resident, may not face the
(production, marketing sourcing, etc.) but also on the
same restrictions, or the restrictions it does face may
financial side (currency of denomination of monetary
be less severe. Thus, the firm is in a better position to
assets and liabilities). In the absence of this informa-
obtain a low-cost hedge.
tion the individual cannot make an optimal exposure
decision.
Structural Barriers
Baron [3], in deriving his concept of "homemade
Some structural barriers have already been com- covering" under which investors are indifferent to a
mented on above in connection with the discussion of firm's covering decision, assumes that output levels,
size barriers. production, and cost functions are deterministic and
The choice of currency for intercompany invoicing, are known to all investors. With all this information,
leads and lags of intercompany or third-party pay- the investor can plan to cope with his residual expo-
ments, and judicious transfer pricing of both financial sure. This view assumes, in addition, zero transaction
and real resources are some of the techniques for mov- costs. It appears that this type of information is fre-
ing funds across borders and thus altering exposure. quently unavailable to shareholders, and even under
These techniques are available only to firms, not to the most extensive disclosure rules, management will
individuals. In some cases, the firm is able to increase have a distinct edge over outside investors in forecast-
its level of local currency debt, which provides it with ing more accurately future prices, sales volumes, and
a desired hedge when operating cashflows are deter- costs. Thus, hedging activity at the level of the firm
mined by the local currency, and this also arbitrages seems preferable to that by an individual.
imperfections stemming from different tax systems As a result of barriers and information gaps, the firm
and capital market regulations. To illustrate, many faces lower (or no) additional transaction costs for
countries not only maintain exchange controls, but many decisions involving hedging. The information
also ration credit resources in the domestic market, required to make hedging decisions may already have
thus keeping interest rates artificially low. Therefore, been collected by the firm for other purposes, such as
for the multinational firm that obtains access to local planning for future sales, production, and financing.
sources of funds, arbitraging and hedging may turn out Thus, information gathering for hedging involves no
to be a joint decision (for details see [5, pp. 78-79]). In additional opportunity cost. In contrast, an individual
addition, from a regulatory point of view, the hedging may have to incur considerable costs to obtain the
aspect of such a financing activity may prevent the same amount of information.
unfavorable attention from government agencies or ad- Given these advantages for firms, corporate hedging
verse public relations that a pure arbitrage decision is preferable to investors' hedging, even though in an
would invite. This is due, of course, to the fact that idealized world they are perfect substitutes. This has
hedging tends to have the connotation of being consis- clearly been recognized by Aliber in a somewhat dif-

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DUFEY, SRINIVASULU/CORPORATE MANAGEMENT OF FOREIGN EXCHANGE RISK 59

ferent context: "The firm may have superior knowl-about their jobs, promotions, and rewards. Indeed, the
edge and may be able to protect against these risks atlargest proportion of managers' total portfolio tends to
lower costs" [2, pp. 134-135]. be invested in their careers; thus, they hold very undi-
versified portfolios. For that very reason managers
4. The Concepts of Self-Insurance and have a strong interest in avoiding even questions as to
Market Efficiency the quality of their performance stimulated by an un-
The first argument based on the concept of self-
due variability of results:
insurance is that forward exchange markets do not The managers may be concerned that occasional
provide bargains, but only fair gambles [7]. In otherlosses incurred from maintaining an exposed posi-
words, by leaving foreign exchange positions uncov-tion would weigh more heavily against their long-
ered, a firm may experience gains and losses. These term performance and career prospects. ... [2, p.
gains and losses tend to average out over a longer 134]
period, and hence an open position is essentially the
same as a hedged position [2]. The implication is thatThis is hardly surprising when consideration is giv-
one should maximize the expected value without un-en to the time horizon of a typical financial manager
due concern for the variance of returns. Thus, thiswhich is likely to be considerably shorter than the
approach assumes risk neutrality on the part of thetime period required for the impact of exchange
decision maker. market disturbances on a firm's portfolio to net to
On a similar but more sophisticated level, it is ar- zero. [14, p. 521]
gued that since foreign exchange markets are efficient Evidence regarding managerial attitudes toward for-
in the sense that forward contracts are priced on the eign exchange risks is provided by Rodriguez [19].
basis of all currently available information, one cannot Managers certainly have a strong interest in reducing
earn any excess returns in those markets, and hedging the variability of cash flows and, indeed, all manifesta-
is of no value. To quote, "unless capital market imper- tions of exchange risk.
fections exist and persist, a treasurer . . . engaged in
selective hedging . . . will not be able to earn consis- Regulators
tent foreign exchange profits . . . in excess of those Another party interested in reducing the variability
due to risk taking" [21, p. 51]. of earnings is bank regulators. Governments feel
This argument rests implicitly on an extremely nar- obliged to limit the risk of bank failure. Following
row concept of "hedging": the use of forward con- some spectacular bank failures in the 1970s - most
tracts to lower the effective cost of liabilities and/or to
notably Herstatt Bank (June 1974) and Franklin Na-
increase the return on financial assets. This, however, tional (October 1974) - governments around the
represents the perspective of a speculator in interna- world have stepped up their regulatory activity related
tional financial markets.
to banks' foreign exchange exposure policies.
This reasoning misses the whole point of corporate
hedging. A treasurer wants to hedge not because of his Stockholders
desire for excess returns, but to achieve a level of risk/
There are certain situations where higher variability
return with which his management feels comfortable.
can result in real losses. This can happen in the pres-
By means of hedging, the additional variability intro-
ence of progressive corporate taxation, discriminatory
duced by unexpected exchange rate changes is elimi-
taxes, regulation that depends on the level of profits,
nated; the residual variance in a firm's returns will be
and asymmetric laws regarding the carrying forward or
due only to fluctuations in business activity, the man- backward of business losses.
agement of which represents the essence of the firm's
Whenever there is progressive corporate taxation, a
competitive advantage.
stable stream of earnings is better than a variable one.
Several constituents of a firm are interested in reduc-
In some countries, profits in excess of a certain per-
ing the variance of a firm's returns stemming from
centage of equity are subject to additional special tax-
exchange rate changes. These include managers, bank
es. In these cases, if a firm has highly variable earnings
regulators, stockholders, and creditors.
it may face a higher tax bill than if it had a stable stream
of earnings with the same mean.
Managers
Also, the level of government regulation of corpora-
It has been argued that managers are concerned
tions may be a function of the level of profits. Report-

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60 FINANCIAL MANAGEMENT/WINTER 1983

ing higher profits in one year might mean inviting a

widely held firm with a diverse shareholder group, it
would not be feasible to do so. Not only would the
greater degree of government control in fixing prices
costs of collecting information about shareholders'
or in other matters. If there are limits to the carrying
forward or backward of losses, a variable income consumption bundles as well as their investment posi-
stream might imply a higher tax bill. Under such tions
cir- be prohibitive, but for a group of heterogeneous
cumstances, a stable stream of earnings is to beconsumers-investors
pre- an "optimal hedge" cannot be
ferred to a variable one, even though both mayfound.
have
the same mean. As a practical alternative, the firm should hedge its
If such variation can be avoided by hedging, it pays cash flows in dollars, and individual shareholders, in
to hedge. turn, should hedge their consumption bundles. They
may do so through forward exchange contracts, for-
Creditors
eign currency debt, directly through commodity fu-
As was shown earlier, reducing variability adds tures,
to or simply by taking positions in firms that are
debt capacity by reducing bankruptcy risk. long in commodities consumed by them. According to
the implicit separation axiom, then, firms should
5. Hedging of Consumption Bundles hedge foreign exchange risks and individuals should
hedge consumption risks. To quote:
The ultimate purpose of wealth is consumption;
While the owners of the firm may view profits as a
therefore, changes in one's nominal wealth are irrele-
means to future consumption, and that consumption
vant if those changes are offset by the price changes of
could take the form of goods imported from abroad,
one's consumption bundle. Consider the case of a firm
it still behooves the firm to maximize the certainty
that is owned by an individual, a U.S. resident, whose
of its earnings in the form of the domestic currency
consumption bundle consists largely of Bordeaux
only. Then ... the rather diverse shareholders . . .
wine, French brie, and baguettes. If the firm has cash
can adjust their portfolios to [fit] their own particular
flows determined by the value of French francs, there
patterns of future consumption. ... [16, p. 69]
will be exchange-related gains and losses whenever the
Discussing a paper by Eaker [6], Makin [15] reiterates
dollar/franc rate changes. However, these losses and
the same position:
gains do not concern the shareholder, as his consump-
Since the optimal real bond differs for each investor
tion is only of unique French goods, and therefore his
with different expenditure patterns, which them-
preferred currency is the franc. A positive exposure in
selves change over time, management of real risks
francs hedges his consumption risk: whenever the
must be done at the investor level . . . information
franc strengthens, his wealth in U.S. dollars will be
costs suggest that investors may find it easier to
greater, but he will need more dollars to buy his con-
diversify real risks on their own while leaving man-
sumption goods. The reverse occurs when the direc-
agement of foreign exchange risk to company man-
tion of change is the opposite. These considerations
agers. [p. 441]
form the basis for the argument that exchange-related
Thus, two conclusions emerge: It is difficult for
gains and losses may be desirable [7, pp. 213-215].
shareholders to hedge the foreign exchange exposure
Of course, this is true only if there is a perfect
of their firms; and it is equally difficult for the firm to
correspondence between the nature of the firm's expo-
hedge the consumption bundle of its shareholders.
sure and the consumption bundle of its shareholders.
The mere fact that shareholders consume imported
goods does not imply that exchange-related gains and6. The Uncertainty of Forward Rates and
losses are desirable. In the example cited, if the firmSpot Rates
had exposure only in Deutsche marks and its share-The argument here is that both future forward rates
holder consumed only French goods, there obviously and future spot rates are variable, and predicting future
would be undesirable exchange risk. The hedging forwardof rates is as difficult as predicting future spot
rates; hence, hedging is of dubious value [21, 8].
the consumption bundle would require selling DM for-
ward for francs. Consider an example, using the same notation as
At this point the question arises, who should hedgethat used in Shapiro and Rutenberg [21]. For the next
the consumption bundle? If a firm has only a few N years, a firm has yearly local currency (LC) earnings
equal to C. The earnings, C, are fixed in LC, will not
shareholders, it may be feasible for it to hedge the
consumption bundle of its shareholders. But forvarya with the exchange rate, and accrue to the firm at

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DUFEY, SRINIVASULU/CORPORATE MANAGEMENT OF FOREIGN EXCHANGE RISK 61

the end of each year. In other words, the firm has for
an N which the firm's planning and action h
year LC annuity of C. It has two alternatives for con-
equal to the maturity of the forward contract,
verting the LC proceeds to its home currency (HC), isthe
useful. The question to ask is: What is th
dollar. planning and action horizon relative to the m
In the first alternative, it can wait each year for the
the forward contract? The crucial issue then is
receipt of LC and convert it to HC at the prevailingtinguish
spot between interperiod variance and int
rate. Let e, be the spot exchange rate ($ per LC) at variance.
the
end of year i. In this method, the firm is not hedging. It
has a variable stream of HC cash flow equal to e,C in
Conclusions
year i. Thus,
In an idealized world, without information and
transactions costs, explicit or implicit contract periods,
Cash flow in year i = e,C; i = 1 to N. l(a)
and other obstacles to instantaneous price adjustments,
Its variance = C2var(e,). 1(b) deviations from various equilibrium conditions such as
purchasing power parity, the law of one price, and
In the second alternative, the firm can sell
bothforward at and international Fisher effect would
the domestic
the beginning of each year the C units of LC expected
not occur; neither would firms be exposed to exchange
to be received at the end of the year. Let risk.
Si be However,
the one-because real-world imperfections in
year forward rate ($ per LC) at the beginning of year
markets i. goods and services as well as financial
for real
The firm would then receive S,C units of HC at the end
assets do exist, firms can be subject to exchange risk.
of year i. Its variance depends on the firm's planning
Even when one allows for the existence of corporate
horizon. Consider first the situation where the firm's
exchange risk, a legitimate question can be raised as to
planning horizon is longer than the maturity of the whether this risk should be managed at the level of the
forward contract, i.e., N > 1, say 10 years. In this firm or by the ultimate beneficiaries, the firm's stock-
situation, under the second alternative, the firm's cash
holders. In the spirit of the capital asset pricing model,
flow and its variance are given by the following: for example, management of different risks in different
markets is redundant and can always be bundled to-
HC cash flow in year i = SiC; i = 1 to N. 2(a) gether and passed along to the capital market. Alterna-
Its variance = C2var(S,). 2(b) tively, in the idealized world assumed in the Modiglia-
ni-Miller theorem, corporate hedging and investor
Whether var(e,) is equal to var(Si) is an empirical
hedging are perfect substitutes for each other. Also,
question, but ei is as difficult to predict as Si. In efficiency
various view of arguments applied to foreign ex-
this, both Shapiro and Rutenberg [21] and changeGiddy [8] can be put forth to make the case
markets
argue that both alternatives are equally uncertain and exchange risk management at the cor-
against foreign
hedging provides no real benefit in reducing uncertain-
porate level.
ty. Giddy states the argument succinctly: The objective of this note was to identify compre-
. . . exchanging currency via the forward
hensivelymarket
the various strands of thought that have been
yields just as much uncertainty as would waiting
used to support the relevance of foreign exchange man-
until the payment date and exchanging agement
currency at the in
corporate level. Obviously, some of
the spot market each time. [8, p. 100]
these arguments are related by common factors. In
However, when the firm's planning horizon
making theis
casethe
for considering foreign exchange
same as the maturity of the forward contract
management to (i.e.,
be an appropriate concern of corporate
N= 1), there is one major difference between the atwo
management, limited range of essentially empirical
alternatives. Using the forward market, the firm was
propositions knows
identified, all of which are based on
market imperfections
at the beginning of each year what it is receiving at the - incomplete securities mar-
end of that year. In the unhedged alternative, the transactions
kets, positive firm and information costs, the
does not know until the date of receipt the
deadactual value
weight costs of financial distress, and agency cost
considerations.
of receipts. Thus, in the hedged alternative, the firm If one or more of those conditions ex-
may be able to use the information for corporate
ist, the case forcash
foreign exchange risk management at
planning and working capital decisions. theIn thislevel
corporate case,
is made. The extent to which man-
for each year, the deviation of actual cash flow
agement canfrom
then cope with exchange risk completely
that expected is zero. Thus, in general, for all activities
is a different issue altogether.

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62 FINANCIAL MANAGEMENT/WINTER 1983

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FINANCE DOCTORAL STUDENTS SEMINAR

The fifth annual Finance Doctoral Students Seminar will take place on October 10 as part of
annual meeting of the Financial Management Association in Toronto, Canada. The Seminar is by
only. To apply, a student or his/her faculty advisor should send a completed application form an
dissertation proposal or abstract to the seminar coordinator before Monday, August 6, 1984.
Further information and applications can be obtained from the 1984 Seminar coordinator
Dennis E. Logue, Amos Tuck School of Business Administration, Dartmouth College, Han
Hampshire 03755. 603/646-2830.

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