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

A manufacturer's board is deciding whether to hedge foreign currency cash flows. Which statement best describes a rationale, under the theory of corporate risk management, for hedging at the firm level even though shareholders could diversify themselves?

Hedging can reduce expected costs of financial distress and help preserve internal funds for investment. Shareholders can diversify, but distress costs, tax convexity and underinvestment are firm-level frictions that hedging can reduce. Hedging does not inherently raise expected cash flows or remove basis risk.

  1. AHedging raises the expected value of the firm's cash flows by exploiting forward mispricing
  2. BHedging can reduce expected costs of financial distress and help preserve funding for investmentCorrect
  3. CHedging eliminates all basis risk and therefore all earnings volatility
  4. DHedging increases the firm's systematic risk and so lowers its cost of capital

Explanation

Reducing cash flow volatility lowers the probability and expected cost of distress and helps ensure internal funds for positive-NPV investments. Hedging does not by itself raise expected cash flows, can leave basis risk, and does not lower cost of capital by raising systematic risk.

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