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

Which of the following is the most defensible argument, under the Modigliani-Miller framework with frictions, for a publicly traded firm to hedge its commodity price exposure, given that shareholders can diversify on their own?

The strongest rationale is that hedging reduces expected costs of financial distress and protects the firm's ability to fund positive-NPV projects. Since shareholders can diversify, hedging only adds value through market frictions such as distress costs, taxes, and underinvestment problems.

  1. AHedging lowers the expected costs of financial distress and helps preserve funding for positive-NPV investmentsCorrect
  2. BHedging raises the firm's systematic risk, increasing the discount rate
  3. CHedging allows shareholders to earn the risk-free rate on their equity
  4. DHedging removes the need for the firm to hold any equity capital

Explanation

In a frictionless world hedging is irrelevant, since investors can diversify. Value arises from frictions: distress costs, taxes, and underinvestment when internal cash flow is volatile. Option B is wrong because hedging does not increase systematic risk, and C and D are not valid rationales.

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