situations where financial distress or even bankruptcy are encountered. Wages, debt
service, and other fixed claims have to be met by the corporation regardless of its
profitability. With higher variance of corporate earnings it is therefore more likely
that situations arise where income is too low to serve fixed financial commitments,
thus getting the company into financial distress. These negative events, however,
have special, discrete costs associated with them. There are direct cost such as bank-
ruptcy proceeding and legal cost, as well as indirect cost that come in many different
manifestations. They result in higher contracting costs with suppliers, customers, and
employees. Management’s attention will be less focused on value-creating opera-
tions; profitable investment opportunities may be passed up due to increased diffi-
culties in raising the necessary funds. By stabilizing the income stream to the corpo-
ration, corporate hedging activities reduce the probability of financial distress. Thus,
as with taxes, expected corporate value is increased to the advantage of shareholders.
Risk management, by reducing the firm’s costs of financial distress, also increases the
corporation’s debt capacity. This leads to a higher optimal debt–equity ratio which
means benefits from increased tax shields.
Another important argument to support the concept of corporate hedging has been
brought forth: Under often realistic conditions of additional costs, such as under-
writing fees, and so on, the variability of funds generated by the company will have
undesirable effects on its investment and/or financing policies in that it increases
their volatility, too (Froot, Scharfstein, and Stein, 1993). As a result, investment op-
portunities with positive net present values (NPVs) might be passed up as a result of
a shortage of funds available or outside financing will be necessary. A corporate risk
management program creates value to shareholders in that it ensures that the com-
pany always has sufficient funds to make value-enhancing investments independent
of otherwise disrupting movements of external factors.
Risk management can also mitigate the problem of conflicting interests between
shareholders and bondholders of the firm. If the company is highly leveraged and
firm value is low, profitable investment opportunities might be passed up because
shareholders have little interest in undertaking these projects since their benefits ac-
crue to bondholders (this is known as the “underinvestment problem”). They might,
however, be interested in taking on high-risk, high-return projects as this will trans-
fer wealth from bondholders to shareholders. Higher variability of firm value will in-
crease the value of the shareholders’ claims because the value of their call option in-
creases with higher volatility of the underlying assets’ value. Bondholders try to limit
such behavior via bond covenants. As hedging can reduce the variability of firm
value, it is apt to mitigate the conflicts between shareholders and bondholders, be-
cause situations where firm value is low are avoided or appear less frequently (Levi
and Serecu, 1991).
Two additional aspects arise in the context of employee compensation and its link-
age to the performance of the employing firm: Whereas the dependence of the em-
ployees’ income on corporate performance basically represents a hedge for owners of
small corporations, this effect is rather negligible for large corporations in which
shareholders hold diversified portfolios. On the contrary, if the company has more
stable income streams due to its hedging activities and does not have to link its em-
ployees’ income to its revenue, it does not have to compensate its employees for tak-
ing on some of its risks either. Thus, the savings in the wage bill goes to the share-
holders.
Tying management compensation to the firm’s performance raises yet a second
6.2 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK? 6 • 5