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

A manufacturer's internally generated cash flow is volatile. In bad years it must cut R&D spending, forgoing projects with positive NPV, because external financing is costly. Which hedging rationale does this describe?

This describes reducing the underinvestment problem. When external financing is costly and internal cash flow is volatile, a firm may cancel positive-NPV projects in bad years. Hedging stabilizes internal cash flow so those investments can still be funded.

  1. AReducing the underinvestment problemCorrect
  2. BExploiting convexity of the tax function
  3. CEliminating the agency cost of free cash flow
  4. DMatching the firm's beta to the market

Explanation

Costly external finance means cash shortfalls force cancellation of valuable investments. Hedging stabilizes cash flow so the firm can fund them. Tax convexity relates to taxes, not investment, and free cash flow agency costs concern excess cash.

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