issue. Various measures of corporate performance (such as earnings of the stock
price) often represent a basis for upper-management compensation. As hedging re-
duces the impact of risks that are not under management control on these measures,
it makes the incentive structure more effective. By the same token, managers have
only limited ways to diversify their personal stake given their large interest in the per-
formance of the company. Moreover, since managerial success or ability is hard to
estimate, corporate performance measures will almost by necessity serve as proxies
for management evaluation. As a consequence, managers will favor lower variability
of firm value (unless their compensation increases with higher volatility, as for ex-
ample with stock options) in order not to lose the present value of their future income
from their current employer. This however may raise the problem that the optimal
risk management strategy to managers is not necessarily the best for the firm, an issue
which can be solved by separating the actually implemented risk management policy
from that used as a base for management compensation (Fite and Pfleiderer, 1995).
Finally, there usually exist information asymmetries between the firm’s manage-
ment and the market. Hedging can help securities analysts to get a more precise esti-
mate of the value of the firm’s assets assuming that the firm’s exposure is not entirely
known to market participants. It then represents an alternative to information disclo-
sure which has the advantage that investors do not have to go through the difficulty
of analyzing all relevant information in order to get a comprehensive picture of the
company’s exposure. Also, the higher quality of information about the firm enables
management to do a much better job at risk management than the individual investor
could do. As will be shown in the material that follows, the assessment of exposure
to exchange rate fluctuations requires detailed estimates of the susceptibility of net
cash flows to unexpected rate changes (Dufey and Srinivasulu, 1984).
All the above considerations basically rest on the assumptions that equilibrium
such as PPP and IFE do not hold, since if they did, hedging would not be necessary.
Whereas these equilibriums tend to persist in the long run, they do not in the short
run. Therefore, risk management does matter to corporations if shareholder value is
to be maximized. An important result and consequence is that a passive strategy to-
ward risk can be quite costly in that it means to take on certain risks on purpose.
Hedging considerations are at the same time interdependent with general business
planning, as there are different ways to affect exposure: measures that affect exposure
per se and measures that reduce risk by establishing offsetting (financial) positions.
In addition, companies are now focused more on consolidated measures of risk, in-
cluding interest rate and commodity and credit risk, instead of segmenting currency
risk into a bucket of its own. The most popular methods are variants on value-at-risk
(VaR) or its flow equivalent, cash flow-at-risk (Smithson, 1998, and Jorion, 2000).
6.3 ECONOMIC EXPOSURE, PURCHASING POWER PARITY, AND THE INTERNA-
TIONAL FISHER EFFECT. Exchange rates, interest rates, and inflation rates are
linked to one another through a classical set of relationships at the level of the econ-
omy that have import for the nature of foreign exchange risk at the level of the firm
also. These relationships are: the Purchasing Power Parity Theorem, which describes
the linkage between inflation rates differentials and exchange rates changes; the In-
ternational Fisher Effect, which ties interest rate differences to exchange rate expec-
tations; and the Unbiased Forward Rate Theory, which relates the forward exchange
rate to exchange rate expectations. These relationships, along with two other “parity”
linkages, are illustrated in Exhibit 6.1.
6 • 6 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK