Managing Corporate FX Risk: A Value-Maximizing Approach

Financial Management (Financial Management Association), Autumn, 1999 by Tom Copeland, Maggie Copeland

Minimizing the probability of business disruption is presented as an objective for FX hedging programs. Within this context firms hedge when the benefits, defined as the reduction in the expected costs of business disruption, exceed the expected costs. This policy is value-maximizing for the firm. Minimization of the variance of hedged operating cash flows, the usual approach, is an insufficient condition for minimizing the probability of business disruption within a predetermined period of time. In addition to the variance of hedged cash flows, two additional variables are important: 1) the ratio of operating cash inflows to cash outflows that represent the business disruption boundary--a coverage ratio, and 2) the reduction in the drift in operating cash flows caused by FX hedging costs. These factors are found to be important in the empirical literature that examines motivations for hedging.

* The main contribution of this paper is the introduction of a value-maximizing approach to hedging, namely maximization of the value of the firm by trading off reductions in the expected cost of business disruption against the expected cost of the hedge. Stultz (1996) proposed a related objective function, "the elimination of costly lower-tail outcomes." Our approach first finds the hedge ratio that minimizes the probability of business disruption within a predetermined interval of time, then evaluates a benefit-cost ratio given the hedge. The benefit is defined as the expected reduction in business disruption cost provided by the hedge, and the cost is the direct cost of the hedging program.

Other recent papers on hedging use different approaches, but obtain similar results. Mello and Parsons (1999) develop a value-maximizing hedging policy wherein business disruption costs are proportional to the value of the firm and hedging changes the probability of exhausting the firm's cash balances, thereby changing the firm's value. Thus, hedging creates value by relaxing a constraint. Froot, Sharfstein, and Stein (1993) motivate rational hedging by assuming that external financing is more expensive than internal financing due to additional (deadweight) costs that are reduced by (costless) hedging. [1]

Our paper also places hedging within a valuemaximizing context and draws out the salient empirical implications. We show that variance reduction per se is neither a necessary nor a sufficient condition for reducing the risk of business disruption. Other factors, including the change in the drift in cash flows induced by the FX position (e.g., transaction costs) and a cash-flow-coverage ratio, must also be considered. For example, if the FX-induced change in drift is negative and the variance reduction from the hedge is low, then the FX hedge can easily increase the probability of business disruption, and therefore its expected cost.

I. The Costs of Business Disruption and Hedging

Support for the point of view that business disruption costs are large is growing. Warner (1977) analyzed the direct costs (e.g., lawyer's and accountant's fees, other professional fees, and lost managerial time) of 11 railroad bankruptcies between 1933 and 1955 and found that they averaged 1% of the market value of the firm seven years prior to bankruptcy and 5.3% of the value immediately prior to bankruptcy. Altman (1984) studied 12 retailers and seven industrials that went bankrupt between 1970 and 1978 and found that indirect bankruptcy costs were 8.1% of the value of the firm three years prior to bankruptcy and 10.5% the year of the bankruptcy. Altman also studied seven firms that went bankrupt during the 1980-1982 interval, finding that average indirect bankruptcy costs were 17.5% of the value of the firm one year prior to bankruptcy. Froot, Sharfstein, and Stein (1993) argue that positive-NPV opportunities (e.g., R&D projects) may be lost when business disruption occurs because cash flows are unexpectedly low. Other examples of indirect costs are that suppliers may be slow to deliver when dealing with a customer firm that is in distress, customers may shy away from a firm that may not survive to be in business when its products need servicing, and workers may abandon an employer that is distressed. Furthermore, many business activities need to be continuous to avoid shut down and restart costs. Opler and Titman (1994) found that more highly leveraged firms tend to lose market share and experience lower operating profits than their competitors during an industry downturn--evidence of significant business distress costs.

Although business disruption costs are large, the probability of incurring them is small. On the other hand, the costs of hedging are small but the probability of incurring them is certain if one hedges. The direct costs of hedging, exclusive of management time, are 50 to 100 basis points per year for programs that use forward contracts.

The remainder of this paper turns to a discussion of how to evaluate hedging programs, while maintaining the assumption that hedging policy is determined by the trade-off between the expected costs of business disruption and the expected cost of the hedge. Potential tax motives, increased debt capacity, and the creation of new business opportunities are not considered in our model.