The Strategic Motives for Corporate Risk Management

This paper investigates how the benefits of hedging currency risk and the incentives of a firm to hedge are affected by the hedging strategies of competing firms. In competitive industries, if currency hedging is uncommon, prices are expected to positively co-vary with exchange rate related cost shocks providing firms with a ‘natural hedge’. As the extent of currency hedging in an industry rises, prices become less sensitive to exchange rates, making profits more random. This suggests that, insofar as randomness in profits is undesirable, the decision to remain unhedged hurts expected profits more if a higher fraction of competitors are hedged. Consistent with this, I find that a firm’s decision to remain unhedged hurts its value more if a higher fraction of competitors hedge exchange rate risk. Consequently, firms are more likely to hedge currency risk if a higher fraction of their competitors do so, even after controlling for industry level exposures to currency risk. These strategic incentives are robust and appear to be more important for currency hedging decisions than some of the firm-specific factors highlighted by existing theory. _________________ Ph.D. Candidate, Department of Finance, University of Michigan, 701 Tappan Street, Ann Arbor, MI 48109. Tel: (734) 657-6069. Fax: (734) 647-8133. Email: [email protected]. The author thanks Sugato Bhattacharyya, Amy Dittmar, Adair Morse and Vikram Nanda for helpful comments