Corporate Hedging, Investment and Value

44 Pages Posted: 19 Mar 2008 Last revised: 26 Jan 2011

See all articles by Jose M. Berrospide

Jose M. Berrospide

Board of Governors of the Federal Reserve System

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: December 23, 2010

Abstract

Following a severe currency crisis in 1998, the Brazilian economy switched from a fixed to a floating exchange rate regime in 1999. Brazilian firms that had accumulated foreign currency liabilities in the fixed exchange rate regime suddenly found themselves exposed to significant currency risk. The temporary disequilibrium created by this shock allows us to trace the causal effect of currency hedging on corporate performance and firm value. We find that hedging allows a firm to insulate its capital expenditure from variation in operating cash flow. That is, it mitigates the underinvestment friction of Froot, Scharfstein and Stein (1993). Hedging also increases the foreign debt capacity of a firm at a time when domestic capital is scarce, allowing the firm to increase the level of investment. Both these channels lead to an improvement in the value of the firm.

Keywords: Currency derivatives, firm value, underinvestment, debt capacity, cost of capital

JEL Classification: G28

Suggested Citation

Berrospide, Jose M. and Purnanandam, Amiyatosh and Rajan, Uday, Corporate Hedging, Investment and Value (December 23, 2010). EFA 2008 Athens Meetings Paper, FEDS Working Paper No. 2008-16, Available at SSRN: https://ssrn.com/abstract=1009657 or http://dx.doi.org/10.2139/ssrn.1009657

Jose M. Berrospide

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
(202) 452-3590 (Phone)

Amiyatosh Purnanandam

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Uday Rajan (Contact Author)

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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