cial as well as nonfinancial, can be observed to devote efforts and resources to the re-
duction of risk. Obviously, corporations do concern themselves with the variability
of their earnings or market value. As documented by a survey of derivatives usage,
U.S. nonfinancial firms quite often even employ derivatives in order to hedge prima-
rily anticipated (77%) or firm–commitment (80%) transactions with the overall ob-
jective of minimizing the fluctuations in the company’s cash flows (67%) (Bodnar,
Hayt, Marston, and Smithson, 1995). Also, there is some evidence (Jorion, 1990, and
Barton, Bodnar, and Kaul, 1994) suggesting that stock prices are adversely affected
by foreign exchange changes.
The observed relevance and importance of risk management to corporations has
led also to the development of positive theories that try to explain this phenomenon.
Turning the classic Modigliani-Miller Theorem around, one can argue that if finan-
cial policies affect corporate value, it must be because of their impact on transaction
costs, taxes, information asymmetries, or investment decisions. Thus it is that the
model’s assumptions may not hold that establishes the case for corporate risk man-
agement.
There are two conditions that a corporate hedging strategy has to meet in order to
be justified on economic grounds: There have to be benefits to the company’s share-
holders greater than the cost of that hedging strategy; and risk management on the
corporate level must be the way to realize these benefits at least cost. In general, this
can be the case if risk management increases the expected cash flows from the firm
to shareholders and/or if the discount rate that is applied to calculate the cash flow’s
present value is lowered. As will be shown most of the value of hedging is generated
from an increase in cash flows rather than a decrease in the discount rate.
Analyzing first the risks shareholders bear and the benefits that can be derived
from corporate hedging, it follows that there are arguments that do justify risk man-
agement at the corporate level for the benefit of shareholders (although the potential
gain might in most cases be quite small). Assuming (domestically) well-diversified
investors, most of the value to shareholders will come from corporate hedging in case
it functions as a means to substitute for international diversification: Corporate risk
management can have the effect of international diversification in that certain risks,
for example, oil price risk, could be transferred abroad, thus reducing the exposure
in both countries. If this hedging transaction is associated with a fixed cost, the firm
will be able to accomplish the hedge at a lower cost than the individual investors, that
is, the firm has to take some action anyway in the course of its normal business. Also
risk sharing with privately held companies might be beneficial for investors if they
could not trade these firms otherwise.
Apart from these direct effects on shareholders’ wealth—often difficult to prove
because of the diversity of individual investors’ interests and preferences—there are
several benefits that come from corporate hedging that affect the value of the com-
pany and thus the wealth of all shareholders. The existence of taxes represents one
argument in favor of corporate hedging, provided the tax code is nonlinear. At first
shown in detail by Smith and Stulz (1985), expected corporate after tax income and
thus cash flows to the shareholders increase with lower volatility of pretax income in
the presence of convex tax structures. Since risk management policies aim at the re-
duction in earnings variance, they effectively reduce the company’s average long tax
rate and create gains that shareholders could not realize otherwise.
A reduction in corporate income variability is a value-creating activity for another
reason. The idea is that higher volatility of firm value implies a higher probability of
6 • 4 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK