Exchange Risk Management and Corporate Capital Structure

Bhagwan Chowdhry

University of California at Los Angeles, Anderson Graduate School of Management from Anderson Graduate School of Management, UCLA

Abstract: We analyze hedging policies for a corporation that generates a foreign currency cash flow that is not known with certainty. We first show that if investors care about real rather than nominal cash flows, there are no "free lunches" due to the Siegal Paradox. THe profile of cash flows that accrue to the equity holders of the firm in various states is completely dtermined by the contractual value of the firm's foregin currency liability could always be chosen to be a foward contract to deliver the foreign currency. We obtain an intriguing result that the probability of bankruptcy for a film that attempts to minimize this probability is lower when htere is some uncertainty in the exchange rates than when there is no uncertainty in the exchange rates: the firm reduces the probability of bankruptcy by borrowing more than its financing needs through foregin currency borrowing alone and by investing the excess funds in domestic risk free securities. Our result provides a reationale for why firms amy choose not to invoice their products in a currency that has no inflation variability; this may also explalin why forms choose to write contracts in nominal rather than real terms.

Date: 1992-03-01
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