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Exchange Risk Management and Corporate Capital Structure

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Author Info
Bhagwan Chowdhry (Anderson School of Management)
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.

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File URL: http://repositories.cdlib.org/cgi/viewcontent.cgi?article=1158&context=anderson/fin
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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number 1158.

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Date of creation: 01 Mar 1992
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Handle: RePEc:cdl:anderf:1158

Note: oai:cdlib1:anderson/fin-1158
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  1. Stulz, Ren? M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June. [Downloadable!]
  2. Black, Fischer, 1990. " Equilibrium Exchange Rate Hedging," Journal of Finance, American Finance Association, vol. 45(3), pages 899-907, July. [Downloadable!] (restricted)
  3. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  4. Shapiro, Alan C., 1984. "Currency Risk and Relative Price Risk," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(04), pages 365-373, December. [Downloadable!]
  5. Smith, Clifford W. & Stulz, Ren? M., 1985. "The Determinants of Firms' Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(04), pages 391-405, December. [Downloadable!]
  6. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 393-414, July. [Downloadable!] (restricted)
  7. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January. [Downloadable!] (restricted)
  8. Hodder, James E., 1982. "Exposure to exchange-rate movements," Journal of International Economics, Elsevier, vol. 13(3-4), pages 375-386, November. [Downloadable!] (restricted)
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