150 CHAPTER 4. UNDERSTANDING FORWARD EXCHANGE RATES FOR CURRENCY
As illustrated in the example, the expected spot rate is not needed in order to
value this position, and discounting can be done at the risk-free rate of return. In
contrast, if you had tried to value the position using the left-hand side of Equation
[4.22], you would probably have had to discount the expected future spot rate at
some risk-adjusted rate. Thus, the first problem would have been to estimate the
expected future spot rate. Unlike the forward rate, this expectation is not provided
in the newspaper or on the Reuters screens. Second, you would have had to use some
asset-pricing theory like the international Capital Asset Pricing Model (capm) to
calculate a risk-adjusted discount rate that we use on the left-hand side of Equation
[4.22]. In this second step, you would run into problems of estimating the model
parameters, not the mention the issue of whether thecapmis an appropriate model.
In short, the forward rate simplifies decision making considerably. We shall use this
concept time and again throughout this text.
4.4.7 Implication for the Relevance of Hedging
In this mercifully short last section before the wrap-up, we briefly touch upon the
implications of the zero initial value for the relevance of hedging, that is, using
financial instruments to reduce or even entirely eliminate the impact of exchange
rates on the cash flow. Forward contracts are a prime instrument for this purpose:
if one contractually fixes the rates at which future exchanges will be made, then
the future spot rate no longer affects your bank account—at least not for those
transactions.
The zero-value property has been invoked by some (including me, whenvery
young) as implying that such hedging does not add value, or more precisely that
any value effects must stem from market imperfections. This is wrong, but it took
me some time to figure out exactly what was wrong.
The argument views the firm as a bunch of cash-flow-generating activities, to
which a hedge is added. The cash flow triggered by the hedge is some positive or
negative multiple ofS ̃T−Ft,T, and itsPVis zero the moment the hedge contract
is signed. True, it’s value will become non-zero one instant later, but we have no
clue whether this new value will be positive or negative; so our knowledge that the
zero-value property is short-lived is of no use for hedging decisions. But does zero
initial value mean that the hedge is (literally) worthless? There can be, and will be,
a value effect if the firm’s other cash flows are affected. For instance, the chances
that adverse currency movements wipe out so much capital thatR&Dinvestments
must be cut, or that banks increase their risk spreads on loans, or customers desert
the company, or the best employees leave like rats from a sinking ship—the chances
that all these bad things happen should be lower, after hedging. Perhaps the firm is
so well off that the probability of painful bad luck—bad luck that affects operations,
not just the bank account—is zero already. If so, count your blessings: hedging will
probably not add any value. But many firms are not in so comfortable a position.
To them hedging adds value because it improves the future cash-flow prospects from