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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A firm has a profitable investment program requiring 80 million of capital each year. Internal cash flow is 100 million in a good year and 60 million in a bad year, each equally likely. External financing is very costly. Which statement best describes the rationale for hedging in this case?

Hedging stabilizes internal cash flow near the 80 million needed, so the firm need not cut positive-NPV projects or raise costly external funds in the bad year with only 60 million. This addresses underinvestment caused by financing frictions, which shareholder diversification cannot solve.

  1. AHedging should be avoided, because shareholders can diversify the firm's cash flow risk themselves
  2. BHedging stabilizes internal cash at about 80 million, reducing the chance of forgoing positive-NPV investment in bad yearsCorrect
  3. CHedging increases the expected cash flow above 80 million by exploiting market inefficiency
  4. DHedging is useful only if it reduces the firm's beta to zero

Explanation

Expected cash flow is 80 million, equal to investment needs. Without hedging, the bad year leaves a 20 million shortfall that must be raised externally at high cost or investment cut. Hedging smooths cash flow to near 80 million and avoids underinvestment. Shareholder diversification cannot fix the firm-level financing friction.

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