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

Under the Modigliani-Miller framework with no taxes, no bankruptcy costs, and no information asymmetries, a corporate treasurer argues that hedging a firm's foreign exchange exposure will increase firm value. Which response is most consistent with that framework?

Hedging is irrelevant to firm value in a Modigliani-Miller world, because investors can take the same hedging positions themselves at the same cost. With no frictions such as taxes or bankruptcy costs, corporate hedging cannot create value.

  1. AHedging adds value because it lowers the discount rate on the firm's cash flows
  2. BHedging adds value because shareholders cannot replicate it
  3. CHedging is irrelevant to value because investors can hedge on their own at the same costCorrect
  4. DHedging destroys value because it eliminates the risk premium earned by shareholders

Explanation

In a perfect market, firm value depends on cash flows, not financing or risk-management choices, because investors can undo or replicate hedges in their own portfolios at equal cost. Hedging therefore neither adds nor destroys value. Diversifiable or hedgeable risk earns no premium, so the risk-premium claim is wrong.

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