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

Which of the following is the most direct way in which hedging can reduce the expected costs of financial distress for a leveraged firm?

Hedging reduces expected distress costs by lowering the probability that cash flows fall short of debt obligations. A narrower cash flow distribution means fewer states in which bankruptcy or forced restructuring costs arise, preserving firm value for stakeholders.

  1. AIt lowers the probability that cash flows fall below the level needed to service debtCorrect
  2. BIt increases the firm's debt tax shield by reducing leverage
  3. CIt eliminates the firm's idiosyncratic and systematic risk simultaneously
  4. DIt transfers the firm's equity risk premium to bondholders

Explanation

Distress costs arise when cash flows are insufficient to meet obligations. Hedging narrows the distribution of cash flows, cutting the probability of falling below the debt-service threshold and thus expected distress costs. It does not directly alter the tax shield or eliminate all risk.

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