A Framework for Cross-Border Investment and Currency Hedging Decisions

Kirt C. Butler 1 and Gwinyai Utete 2 May 12, 2011 Textbook valuation of a cross-border capital budgeting project is set in a stylized world that assumes the international parity relations hold in integrated financial markets. The financial managers exchange rate view and the projects operating exposure to currency risk are ignored. In such a world, the value of a cross-border project is the same whether viewed from the parents or the projects perspective. Complications in the real world include disequilibria in the international parity relations, managerial exchange rate forecasts that differ from parity, non-trivial operating exposures to currency risk, and the parent firms currency hedging strategy. Managers exchange rate forecasts in particular can have a profound impact on estimated project values and the currency hedging decision. The authors include these real-world complications in a comprehensive valuation framework, and show how the relative magnitudes of these effects influence managers behaviors and the multinational corporations currency risk management decisions. Key words: Cross-border; Capital budgeting; Currency risk; Currency hedging; Disequilibrium JEL classification: F3; G3

Corresponding author: Department of Finance, The Eli Broad College of Business, Michigan State University, East Lansing, MI 48824, USA. butler@msu.edu. 1-517-980-0663. 2 Department of Finance, College of Business, Auburn University, Auburn, AL 36849, USA. gtu0001@auburn.edu. 1-334-844-5520.

Introduction
In principle, there is little difference between domestic and cross-border project valuation. From the perspective of a domestic parent, project value is still the present value of expected cash flows discounted at the appropriate risk-adjusted cost of capital. Projects should be undertaken only if the present value of the expected cash inflows exceeds their cost. Although the basic principle is the same, cross-border valuation is more complex because the project can be valued either in the local (foreign) market or from the domestic perspective of the parent corporation. In practice, a number of real-world factors impact these relative valuations including disequilibria in the international parity relations, exchange rate expectations that differ from parity, the projects operating exposure to currency risk, and the parents currency hedging strategy. A managers exchange rate view in particular has a profound impact on the expected value of a cross-border project and on whether the cash flows from the project should be hedged against currency risk. Surveys find that financial managers believe they possess information that provides them with an advantage in anticipating financial price movements, and that they incorporate these views into their risk management decisions.1 The influence of this view is generally acknowledged, yet its implications for project selection and currency risk management are rarely discussed. In this article, we use the parents domestic perspective on cross-border project valuation to guide the project selection and currency risk hedging decisions. Project valuation and the firms hedging decisions are invariably entangled with broader financing issues including multinational tax considerations, the firms risk management and financial structure policies, a projects debt capacity, and the parents portfolio of real and financial assets and liabilities. To minimize these considerations, we take an adjusted present value approach that assesses financial issues separately from the investment. This allows a focus on the interaction of the cross-border valuation methodology with the currency hedging decision. This perspective is informative because hedging decisions at the level of the project determine both the expected value of the project and the variability of project value.

The International Parity Relations and Exchange Rate Expectations

The international parity relations are central to cross-border capital budgeting. The most important and reliable relation is covered interest parity (CIP) which relates the domestic currency forward price Ft of one unit of foreign currency to the corresponding spot exchange rate S0 through cross-currency differentials in risk-free (f) nominal interest rates in the domestic (if) and foreign (if*) currencies, Ft / S0 = [(1+if)/(1+if*)]t (1)

where if and if* are geometric mean risk-free rates of interest over the t-period horizon. CIP is enforced by risk-free covered interest arbitrage, and so holds within the bounds of transactions costs in liquid financial markets. In practice, Eurocurrency yields on large transactions between money-center banks are a close approximation to risk-free rates of interest. Theory would claim that expected real (inflation-adjusted) returns on risk-free securities should be the same in each currency, but in fact at any point in time there can be cross-currency differences of several percent in expected real returns. CIP only ensures that forward rates reflect the relative nominal opportunity costs of capital in the two currencies.
1

Gczy, Minton and Schrand (2007) and Servaes, Tamayo and Tufano (2009).

Uncovered interest parity (UIP) relates expected t-period spot rates to todays spot rate by adjusting for cross-currency differentials in domestic (i) and foreign (i*) nominal required returns on a particular risky asset, such as corporate debt or a cross-border investment project. E[t]/S0 = [(1+i)/(1+i*)]t (2)

The caret ( ) over the spot rate indicates that this is an equilibrium expectation for a particular risky asset based on that assets relative opportunity cost of capital in the two currencies. Future spot rates are uncertain, so the speculative activity of market participants cannot force this relation to hold at all times. E[t] will differ from Ft when market segmentation results in crosscurrency differences in real required returns or risk premiums on a particular risky asset. If financial markets are integrated and expectations are rational, then the forward exchange rate equals the UIP expectation; that is, Ft = E[t] at each horizon t. Forward parity (FP) is often stated relative to the beginning-of-period spot rate, Ft / S0 = E[t]/S0 (3)

for comparability to the CIP and UIP relations. FP will hold in expectation when a particular asset has the same real or inflation-adjusted required return in the foreign and domestic currencies, so that there is a common risk premium for the asset across the two currencies. In order to value a foreign investment project, a manager needs to form an expectation about future exchange rates. Suppose a manager has an exchange rate view or belief that differs from the forward rate by a percentage dt according to E[St] = Ft (1+dt) = Ft + dt Ft (4)

In what follows, we refer to dt Ft as the forecast component of the managers exchange rate view relative to the forward exchange rate baseline Ft.

Cross-Border Valuation
Cross-border valuation can be approached in two complementary ways. From the projects local perspective, project value is the present value of expected cash flows discounted at the opportunity cost of capital in the local (foreign) currency. The parent can then translate this foreign currency lump sum at todays spot rate S0 to find the value of the project in the parents domestic currency; Projects perspective V = S0 [ t E[Ct*]/(1+i*)t ] (5)

where Ct* is a foreign currency cash flow and i* is the foreign currency hurdle rate. This decentralized approach to project valuation properly values the project in the local currency, but neglects the value to the parent of the projects operating exposure to currency risk. Most managers prefer to take a centralized approach that values domestic currency cash flows to the parent at the domestic cost of capital because this is the value that the parent can expect to capture in the absence of hedging. Expected cash flow from the parents perspective depends on the expectation of the cash flow and the spot exchange rate; E[Ct] = E[Ct*St]. Expected domestic currency cash flows are then discounted at the domestic cost of capital.

There is a nuance here that is omitted from most textbook treatments of cross-border capital budgeting. In particular, the expectation of the product Ct*St is the product of the expectations of Ct* and St plus a covariance term that reflects the projects operating exposure to currency risk; i.e., E[Ct*St] = E[Ct*]E[St] + Cov(Ct*,St). A positive covariance between foreign cash flows (Ct*) and the value of the foreign currency (St) adds to the value of the project, and vice versa. The expected value of a foreign cash flow from the parents perspective is then E[Ct] = E[Ct*St] = E[Ct*]E[St] + Cov(Ct*St) = E[Ct*]Ft + E[Ct*]dtFt + Cov(Ct*,St)

(6)

where the covariance Cov(Ct*,St) is the product of the correlation of project cash flow with the exchange rate, the standard deviation of project cash flow, and the standard deviation of the exchange rate; Cov(Ct*,St) = Corr(Ct*,St) Std(Ct*) Std(St). The net present value of the foreign project from the parents perspective is then the present value of expected domestic currency cash flows discounted at the domestic cost of capital. Parents perspective V = t E[Ct* St]/(1+i)t = [ tE[Ct*]Ft + tE[Ct*]dtFt + tCov(Ct*,St) ]/(1+i)t = V(Ft) + V(Forecast) + V(Covar)

(7)

The V(Ft) term represents the expected value of foreign cash flows converted to domestic currency at the forward rates of exchange. The V(Forecast) term captures the expected gain or loss in value from the managers exchange rate view. The V(Covar) term reflects the projects operating exposure to currency risk. Textbooks in international finance typically ignore the forecast and covariance terms in order to make the method accessible to beginning students. Forward rates are assumed to be unbiased predictors of future spot rates, in which case the value of the forecast term is zero. The covariance of project cash flow with the exchange rate is ignored on the grounds that the exposure is difficult to estimate and small in magnitude. Under these conditions, the project and parent perspectives are both equal to V(Ft). Although this provides beginning students with a simple framework for cross-border capital budgeting, it ignores these potentially important components of project value. These terms can indeed should affect managerial behaviors regarding the firms investment and hedging decisions, and so have real consequences for the firm and its stakeholders. The Managers Exchange Rate Forecast The expected value of the forecast term V(Forecast) can be captured independently of the project if a manager is willing to speculate directly in the markets. If Ft < E[St], then the winning strategy is to buy the foreign currency at Ft in the hope of later selling it at E[St]. Conversely, if Ft > E[St] then the strategy is to sell foreign (and buy domestic) currency at Ft. Although some hedge funds speculate in this fashion, most corporate treasurers eschew outright speculation. Instead, they build their exchange rate views into their project valuations and risk management decisions. Surveys of financial managers and currency professionals find that exchange rate expectations can be quite heterogeneous, so it is worth investigating what the academic literature has to say about exchange rate predictability and the tools that are used to forecast currency values.

Technical analysis is the most popular tool for currency professionals over short forecast horizons. This choice is justified by academic studies that have demonstrated the after-cost profitability of technical trading rules over short horizons, particularly in volatile markets and during central bank interventions.2 One study reported excess returns from technical analysis to be 25 basis points per month or about three percent per year relative to a random walk.3 The popularity of technical analysis arises in part from the fact that forward exchange rates and interest rate differentials fail to predict exchange rate changes over short horizons despite the economic intuition behind the parity relations. Indeed, FP usually points in the wrong direction over short horizons. This failure of FP over short horizons is a long-standing puzzle in finance and is referred to as the forward discount bias or the forward premium puzzle. Although there is little consensus on its cause, possible explanations include a time-varying currency risk premium, a peso problem (a small probability of an extreme event), irrational market behaviors, nonlinearities or regime shifts in exchange rates or interest rates, and changing or persistent currency volatility.4 The forward discount bias is related to the carry trade, a strategy of investing in a high interest currency while shorting a low interest currency. The carry trade is popular because currencies with relatively high interest rates do not tend to depreciate in the near term as predicted by theory. Several vehicles have been introduced to facilitate carry trade strategies including FTSEs forward rate bias indices and Deutsche Banks currency carry exchange-traded fund (ETF). Carry trade returns resemble those of short out-of-the-money puts written on the high interest rate currency, with prolonged periods of small profits interspersed with occasional large losses. Fundamental models that include cross-currency interest differentials assume a more important role over the long horizons that are typical of cross-border investment projects.5 Long-horizon forecasts based on fundamental analysis have been found to be valuable in both developed and emerging market currencies.6 Unfortunately, there have been no studies of the predictive performance of currency professionals over long forecast horizons. Surveys have asked currency traders to identify the long-horizon determinants of exchange rates, but have not attempted to assess their forecasting performance. What is clear is that managers in charge of cross-border projects have both the opportunity and the incentive to bet on exchange rates, and that this has real consequences for the firm and its stakeholders. This is true even if managers forecasts are uninformed and the expected gain of these bets is zero relative to forward exchange rates or to a random walk. The Projects Operating Exposure to Currency Risk Managers are in a much more advantageous position than outside investors to estimate the V(Covar) component of project value. This is not an easy task, as operating cash flows are uncertain and their interaction with the exchange rate depends on many factors including the firms operating decisions and competitors responses to those decisions. Nevertheless, an estimate of the operating exposure term is important for long-lived projects because the magnitude and significance of both cash flow and equity exposures to currency risk increase with the forecast horizon.7

2 3

Menkhoff and Taylor (2007). Pojarliev and Levich (2008). 4 The literature on the forward premium puzzle is reviewed by Engel (1996) and by Jongen et al. (2008). 5 Chinn and Meredith (2004) and Menkhoff and Taylor (2007). 6 Abhyankar, Sarno, and Valente (2005) and de Zwart, Markwat, Swinkels, and van Dijk (2009). 7 Bodnar and Wong (2003) and Bartram (2007).

The magnitude of this term depends on the correlation of project cash flow with the exchange rate, the volatility of the projects cash flow, and the volatility of the exchange rate. Whereas exchange rate volatility can be estimated from market data, terms related to the project are specific to a particular corporate asset and typically are not available to the public. However, asset volatility and equity correlations with the exchange rate are observable at the firm level. This allows a back-of-the-envelope estimate of the magnitude of a typical covariance term based on the literature on asset volatility and exchange rate exposure. The academic literature focuses on the correlation of equity returns with the exchange rate for multinational firms with a high proportion of international operations or sales. Equity value reflects all of a firms assets net of its financing and hedging choices, and so will not be a perfect pure-play for a particular cross-border project. Nevertheless, an assessment of operating exposures based on equity returns can be useful because equity values reflect the aggregate effects of the currency exposures of all future cash flows. Well use the equity of U.S.-based Ford Motor Company to illustrate the potential impact of a projects operating exposure to currency risk. The auto industry is a good candidate for illustrating the relation of currency exposures to competitive conditions because its participants are globally competitive and fairly homogeneous.8 An automakers currency exposure is a function of its foreign sales and production, its foreign competition, and its hedging practices. Over the 2006-2010 period, the correlation of Fords monthly stock return to monthly changes in the dollar-per-pound spot rate was Corr(Fordt,St) 0.251. This positive exposure to the pound reflects the fact that Ford is still predominantly a U.S. exporter, despite its aggressive efforts to globalize sales, production, and operations. An increase in the pound or a decrease in the dollar makes Fords dollar-based cost structure more competitive in global markets. If Ford were to open a new manufacturing plant in the U.K., one can imagine that the operating exposure of the plant would be roughly opposite that of Fords domestic U.S. operations. An increase in the value of the pound would hurt a U.K. plant because its cost structure would increase relative to plants outside the United Kingdom. For illustration, well assume a correlation Corr(Ct*,St) = 0.251 between the plants operating cash flows and the value of the pound. The standard deviation of monthly changes to the dollar-per-pound spot rate was 3.14 percent over 2006-2010. Under the assumption that exchange rates are normally distributed and independent over time, then t-period and one-period exchange rate volatility are related by Std(St) = Std(S1)t. Annual exchange rate volatility is then about Std(St) = 10.9 percent of asset value per year. Although exchange rate volatilities are in fact fat-tailed relative to the normal distribution and change over time, this volatility estimate provides a convenient reference point for our illustration. The final piece of information needed to demonstrate the effects of managerial discretion is a measure of the volatility of a given project's cash flows. Choi and Richardson estimate asset volatility based on returns to a firms liabilities.9 These authors found a mean asset volatility of 11.5 percent per month for U.S. firms with asset size greater than $250 million. On an annual basis, cash flow volatility for a typical asset would then be about Std(Ct*) = 39.8 percent of asset value. Well use this as a proxy for cash flow volatility in our estimate of the importance of the covariance term for a typical project. Note that this will underestimate cash flow volatility for a particular asset

Williamson (2001) studied U.S. and Japanese auto manufacturers in order to assess the impact of domestic and foreign demand elasticities and intra-industry competition on equity exposures to currency risk. 9 See Choi and Richardson (2010), particularly their Table 3B.

because (a) asset volatilities are diversified across the firms heterogeneous assets, and (b) cash flows are less than perfectly correlated over time. To illustrate the possible influence of V(Covar), we combine the correlation of Fords equity return with the exchange rate (as a proxy for Corr(Ct*,St)) with the estimated volatilities of asset value (as a proxy for Std(Ct*)) and the exchange rate Std(St). Using these estimated values yields a covariance term of Cov(Ct*,St) Corr(Ct*,St)Std(Ct*)Std(St) = (0.251)(0.398)(0.109) = 0.0109, or 1.09 percent of asset value. V(Covar) is then the present value of all future operating exposures to currency risk. Well return to these estimates in an example below.

Hedging a Projects Operating Exposure to Currency Risk

Currency risk management is an important function of the multinational treasury. By ensuring more stable cash flows, hedges can combine with an underlying risk exposure to reduce the firms financial distress costs, agency costs, tax liabilities, and cost of capital. Hedging can allow the firm to take advantage of its investment opportunities without having to resort to costly external funds.10 Hedging has value when information asymmetries make it difficult for individual investors to hedge as effectively as insider managers, and can improve the quality or informativeness of earnings as a signal of managerial ability or project quality.11 It is not surprising that studies find risk management can add value to multinational corporations that are exposed to currency risk, often through a judicious combination of operating and financial hedges.12 Operating and Financial Hedges of Operating Exposures to Currency Risk Although surveys find that currency risk is the most important risk faced by the multinational treasury, it is by no means the only risk. Other firms with financial exposures include financial institutions with exposures to interest rate risk and oil companies with exposures to commodity price risk. Surveys of financial managers identify a host of important non-financial risks as well, including strategic risks, competitive risks, execution risks, and reputational risks.13 The most effective way to hedge the uncertain operating cash flows of a foreign project is to use the multinational corporations diversified global operations to form an operating hedge of currency risk. Examples of operating hedges include changes in the firms plant location, product sourcing, and marketing choices. An operating hedge treats the underlying cause of the exposure through changes in the interaction of project cash flows with the exchange rate; that is, through V(Covar). However, an operating hedge involves fundamental changes in operations changes that can entail significant non-recoverable costs and therefore are not zero-NPV choices. An operating hedge requires its own capital budgeting analysis to determine if the proposed changes make sense. Such an analysis is project-specific and is beyond the scope of this article. The most straight-forward financial hedge of a currency exposure is a forward currency hedge of expected after-tax operating cash flow. Close relatives of the currency forward include currency futures, currency swaps, and foreign currency debt.14 Each of these financial contracts locks in a foreign currency cash flow that offsets at least some of the underlying operating exposure. The other side of the financial market hedge is a cash flow in the domestic currency, either in the future as in a forward hedge or today as in the domestic currency value of foreign currency debt.
10 11

Froot, Scharfstein and Stein (1993). DeMarzo and Duffie (1991) and DeMarzo and Duffie (1995). 12 Smithson and Simkins (2005) surveyed the evidence on the value of risk management. 13 Servaes, Tamayo, and Tufano (2009). 14 A currency option hedge has payoffs that are not directly comparable to those of a forward hedge.

Financial hedges such as currency forwards are attractive because they are zero-NPV transactions and can be executed at low cost in liquid markets. The disadvantage of a financial hedge is that the contractual cash flows of a financial transaction cannot exactly offset the uncertain operating cash flows of the firms real assets. Because of this mismatch, it is important for managers to assess the likely performance of a proposed currency hedge. This requires an assessment of the interaction between the operating performance of the project and the exchange rate. The effectiveness of various financial market hedges can then be assessed by varying the type of hedge, the amount of the hedge, and the term or maturity of the hedge. In many cases, management will choose to hedge less than the full amount of the expected cash flow to avoid the risk of overhedging with too large of a forward position relative to the realized operating cash flow. The Impact of a Forward Currency Hedge Consider the exposed operating cash flow Ct* in the top panel of Figure 1. This cash flow is positive for a foreign project that is generating cash inflows. Suppose the parent firm hedges a proportion (0<1) of the expected cash flow such that the hedged amount t* = E[Ct*]. The forward contract has a contractual cash flow t* in the foreign currency and an offsetting cash flow +t*Ft in the domestic currency. The domestic currency value of the operating exposure and of the forward hedge will depend on the spot rate St as shown in the bottom panel of Figure 1. From the parents perspective, hedging transforms the domestic currency value of operating cash flow from an unhedged value Ct = Ct*St into a hedged value Ct(Hedge) = Ct*St + t*Ft t*St. If the magnitude of the exposed cash flow Ct* is known with certainty, then exposure to currency risk can be completely eliminated by setting =1 with a forward contract size of t* = E[Ct*]. In the more general case, Ct* is unknown and the project has an operating exposure to currency risk. The contractual hedge t* and the forward exchange rate Ft are constants, so the expected value of hedged cash flow is E[Ct(Hedge)] = E[Ct*St + t*Ft t*St] = E[Ct*]Ft + (E[Ct*]t*)dtFt + Cov(Ct*,St) The expected value of the hedged project from the parents perspective is then V(Hedged) = t [ E[Ct*]Ft + (E[Ct*] t*)dtFt + t Cov(Ct*,St) ] / (1+i)t = V(Ft) + V(Forecast|Hedge) + V(Covar)

(8)

(9)

The difference in unhedged and hedged project value arises solely from the forecast term. The V(Covar) term is unaffected by a financial hedge because the hedge cash flows are contractual whereas the operating cash flows depend on the projects operations. A financial hedge reduces the parents exposure to currency risk, but has no direct impact on the comovement of the projects operating cash flows with the exchange rate. For a 100 percent (=1) forward hedge t* of expected operating exposure E[Ct*], the expected value of the project reduces to V = V(Ft) + V(Covar).

An Example
Figure 2 provides an illustration of this framework. Suppose Ford Motor Company is considering a manufacturing facility in the U.K. that costs a notional 100 and returns a risky after-tax operating cash flow in one year with an expected value of 110. The appropriate risk-adjusted discount rates for the project are ten percent in each currency, whilst risk-free rates are two percent in each

currency. Since the rates of riskless borrowing are identical, the forward rate will be equal to todays spot rate. Assuming a current spot rate of S0 = $1.50/, one-year forward contracts denoted by F1 will trade at $1.50/ as well. The expected NPV of the project in the U.K. is given by the sum of its discounted cash flows in pounds: V* = E[C1*]/(1+i*) + C0* = (110)/(1.10) 100 = 0 When the U.S. parent converts this amount at the $1.50/ spot rate, the project appears to be worth V = S0 V* = ($1.50/)(0) = $0 (5')

according to the projects perspective in Equation (5). However, this approach critically ignores the impact of the projects operating exposure and the managers exchange rate expectation. The projects operating exposure in a one-period setting is V(Covar) = Cov(C1*,S1)/(1+i). To adapt our earlier estimate of operating exposure to this example, set Std(C1*) = 39.8 (39.8 percent of the 100 investment), Std(S1) = $0.164/ (10.9 percent of the $1.50/ spot rate), and Corr(C1*,S1) = 0.251. The projects operating exposure is then Cov(C1*,S1) = $1.64, or V(Covar) = ($1.64)/(1.10) = $1.49 at the 10 percent opportunity cost of capital in dollars. Suppose the manager believes that the value of the pound will be ten percent higher than the forward rate in one period; that is, E[S1] = F1(1+d1) = ($1.50/)(1.10) = $1.65/. The managers expected present value gain from her exchange rate forecast on this one-period setting is then V(Forecast) = E[C1*]d1F1/(1+i) = (110)(0.10)($1.50/)/(1.10) = $15, or 10 percent of the asset valued at the forward exchange rate. Including both the projects operating exposure and the managers exchange rate expectation, the value of the project from the parents perspective is V = V(F1) + V(Forecast) + V(Covar) = [ $150 + $150 ] + $15.00 $1.49 = $13.51

(7)

The manager forecasts a $15 gain from the anticipated appreciation of the pound relative to the forward rate and a $1.49 loss from the comovement of project cash flows with the exchange rate. A 100 percent forward hedge of the expected pound cash flow (that is, 1* = 110) eliminates the expected gain from the managers exchange rate forecast, resulting in a hedged project value of V(Hedge) = V(Ft) + V(Forecast|Hedge)] + V(Covar) = [(100)($1.50/)+(110)($1.50/)/(1.10)] + (0)(0.10)($1.50/)/(1.10) + ($1.64)/(1.10) = [ $150 + $150 ] + $0 $1.49 = $1.49 (9') The forward hedge foregoes the $15 expected gain from the managers anticipated appreciation of the pound. The net effect is a reduction in the expected value of the project, as well as its variability. In this example, the manager must decide whether and if so how to hedge.

The Hedging Decision

Figure 3 classifies projects according to their expected value from the unhedged and hedged perspectives. Projects for which both values are less than zero as in the top left cell clearly can be

rejected. Projects that fall into the bottom-right cell of Figure 1 clearly should be accepted because both unhedged and hedged values are greater than zero. Comparing the unhedged and hedged values in this cell can help us decide how to approach the currency hedging decision. A forward hedge reduces the expected size of a managers exchange rate bet from E[Ct*] to (E[Ct*] t*), although the ex post size of the bet depends on the actual value of operating cash flow Ct*. The contribution of the managers exchange rate forecast to the expected value of the project depends on the size of the bet and her exchange rate view relative to the forward expectation. The manager has an incentive to hedge the projects cash flows if the forward rate exceeds the forecast (that is, Ft > E[St]) because hedging captures a higher expected project value with lower variability. On the other hand, if the forward rate is less than the managers forecast (Ft < E[St]) then hedging reduces both the variability and the expected value of the project. In this case, a manager seeking to maximize project value has an incentive to leave cash flows unhedged in hopes that the actual spot rate exceeds the forward rate. This unfortunately leaves the parent exposed to currency risk. Positive-NPV When Hedged but Negative-NPV When Unhedged In the bottom left cell of Figure 3, the project is attractive when hedged but unattractive when left unhedged. If the project is accepted, then hedging results in a positive expected value with lower variability. Hedging clearly benefits all stakeholders including management in this case. A negative expected value in the unhedged case can arise when the manager has a pessimistic exchange rate view; E[St] < Ft(1+dt). In this case, the manager can avoid the expected exchange rate loss by hedging the project cash flows. This is a simple and intuitive result. A lower value in the unhedged case also can arise when real required returns or risk premiums are disproportionately high (low) in the domestic (foreign) currency. For this purpose, it is inappropriate to compare i directly to i*. A projects relative opportunity costs of capital must be compared through CIP to determine which interest rate is too high and which is too low relative to parity; i.e. (1+i)t/(1+i*)t vis--vis (1+if)t/(1+if*)t = Ft/S0. Relatively low real required returns or risk premiums in the foreign currency can cause the expected value of the project from the projects local perspective to exceed the unhedged value from the parents perspective. Cross-currency differences in real returns or risk premiums can be substantial in practice. It is worth considering the hedging instrument in this setting. In particular, the relative values of Ft and E[t] determine whether to hedge with a forward-like instrument (a currency forward, futures, or swap) or with foreign currency debt. Suppose the firms all-in borrowing cost is ib in the domestic and ib* in the foreign currency. The forward rate Ft is determined by the CIP ratio of risk-free Eurocurrency interest rates (1+if)t/(1+if*)t. The UIP expectation E[t] for risky corporate debt is determined by relative borrowing rates according to (1+ib)t/(1+ib*)t. If Ft > E[t], then the firm should hedge the operating cash inflows of the project with forwards. In contrast, if Ft < E[t] then the interest rate ib* is a relative bargain and the project should be financed with foreign currency debt. This comparison between Ft and E[t] also sets the standard for the hedged alternative in each of the other cells in Figure 3. If project cash flows are to be hedged, then the rule is to choose the hedging instrument that yields the highest expected value based on the all-in costs of the forward hedge relative to foreign currency debt. Positive-NPV When Unhedged and Negative-NPV When Hedged If the unhedged project is positive-NPV but the hedged project is negative-NPV as in the top right cell of Figure 3, then a partial hedge reduces both the expected value and the volatility of

project value. A larger hedge eventually yields a negative NPV. Whether this project makes sense for the parent depends on the source of the expected gain from the unhedged perspective. A higher value in the unhedged case can arise when real required returns or risk premiums are disproportionately low (high) in the domestic (foreign) currency relative to parity. Relatively low real required returns or risk premiums in the domestic currency cause the expected value of the project from the parents perspective to exceed the value from the projects local perspective. Expected gains from this type of parity disequilibrium should be based on market prices and thus should not be entirely subjective. Nevertheless, risk premiums must be estimated and necessarily involve some managerial judgment. The higher value from the parents perspective also might arise because a managers exchange rate view is optimistic relative to forward prices. This provides an opportunity for a manager to exercise an exchange rate view, but at the risk of missing the mark. Because there is very little evidence that exchange rates can be successfully predicted at long horizons, it seems hard to justify accepting a project for which the source of expected gain is a managers exchange rate forecast. Accepting a project solely to take advantage of a managers forecast is tantamount to outright currency speculation, which need not rely on a risky foreign project that is negative-NPV when hedged against currency risk. Under these conditions, it would seem the parent is better served by continuing to look for positive-NPV projects in the foreign country that dont rely on the managers exchange rate view for their value. OBrien (2004) is more sanguine about investing in a foreign project in order to take advantage of a managers exchange rate expectation. His argument is that managers may want to gamble on the foreign project if outright speculation is undesirable because (a) it is inconsistent with the parent firms business, or (b) operating gains/losses receive a more favorable accounting treatment than speculative gains/losses. We disagree with point (a) even if the firms risk management policy encourages aggressive positions. Accepting a risky cross-border project that is negative-NPV when valued at forward exchange rates hardly seems like a sensible course of action when an outright forward position would achieve a higher expected value at less risk. However, accepting the project might make sense if the additional value comes from the projects operating exposure to currency risk. We are less opposed to point (b), particularly when there are tax considerations that have cash flow implications. In either case, our strong preference would be to continue searching for a positive-NPV investment as the instrument for placing a bet on the managers expectations. A manager that chooses such an aggressive position needs to make sure she is confident of her exchange rate forecast. She also must be prepared to manage her internal and external relations if exchange rates move in the wrong direction and her investment goes awry. Her reward or penalty for placing a speculative bet via a cross-border project will depend on her employers corporate governance policies in general, and on her performance evaluation and compensation contract in particular. Hence, the managers actions in this setting depend on her personal circumstance and the firms risk management policy. Positive-NPV from Both Perspectives Suppose the project has a positive NPV from both unhedged and hedged perspectives, as in the bottom right cell of Figure 3. The decision of whether to hedge the projects cash flows can then be made in light of whether the unhedged or the hedged project value is greater. When the hedged value of the project is greater than or equal to the unhedged value, the corporation clearly should invest in the project and then hedge its exposure to currency risk.

10

Hedging has a double payoff; it maximizes the expected value of the project while minimizing the corporations exposure to currency risk. This should be unambiguously preferred by management as well as by debt and equity stakeholders. The choice of financial market hedge again will depend on whether a forward-like instrument (forwards, futures, or swaps) or foreign currency debt yields the higher expected value. When the hedged value of the project is less than the unhedged value, the firm again should invest in the project. Depending on the financial managers confidence in her exchange rate forecast and the corporations incentive structure and tolerance for risk, managers may consider leaving the investment unhedged to take advantage of the higher value arising from the managers view. However, leaving the cash flows unhedged is risky, and the corporation and its financial officers must be prepared to accept the consequences of an exchange rate bet. A manager operating under effective governance mechanisms will be more inclined to use hedging tools responsibly, as opposed to speculating outright.

Conclusion
Many factors impact the decision of whether to hedge the currency risk exposure of a crossborder project. Hedging decisions must be made in the context of the parent firms portfolio of current and possible future assets and liabilities. These decisions also depend on the size of the expected gain or loss in project value from hedging, the expected reduction in risk from hedging, tax and financial structure considerations, corporate governance issues, the firms tolerance for risk, management review and compensation schemes, and risk management policy. Nevertheless, a comparison of NPVs from the unhedged and hedged perspectives can provide guidance on how to structure a foreign project. We develop a comprehensive framework for value maximization in investment and hedging decisions for cross-border projects. In particular, we expand the parent corporations perspective on the value of a cross-border project into the value of the project at forward rates of exchange, the value of the managers exchange rate view, and the value of the projects operating exposure to currency risk. We then show how the parent firms investment and hedging decisions depend on the relative size, variability, and reliability of these terms. Because it is most subject to managerial discretion, the exchange rate forecast component is an important driver of the accept-reject and hedging decisions and therefore should be of most concern to outside stakeholders. A manager with an optimistic view of the foreign currency relative to covered interest parity may have an incentive to pursue projects of questionable value in order to profit on her forecast. A pessimistic forecast on the other hand leads to either a more aggressive currency hedging program or a shift in the parents financial policies, such as an incentive to use foreign currency denominated sources of capital. In either case, life can be interesting for the manager with an exchange rate view that differs from the forward exchange rate.

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Figure 1 The Cash Flows of an Operating Exposure and an Offsetting Forward Currency Hedge An operating exposure of an amount Ct* at time t is hedged by a forward contract of size t* = E[Ct*] where 0<1. This forward currency hedge creates a foreign currency cash flow of t* and an offsetting domestic currency cash flow of +t* Ft. Parents operating exposure Cash flows in the local (foreign) currency Ct* Forward hedge (t* Ft t*) Net position +Ct* + t* Ft t*

- - - - - - - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - -- - - - Parents cash flows in Ct* St t* Ft t* St +Ct* St + t* Ft t* St the domestic currency at the spot rate St

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Figure 2 An Example of a Domestic U.S. Parent Corporation with a Proposed Project at a U.K. Subsidiary Project characteristics: (1) A notional investment C0* = 100 yields an expected cash flow E[C1*] = 110 in one period. (2) The manager expects the spot rate to be d1 = 10 percent higher than the forward rate F1 in one period. (3) The projects cash flow at time one co-moves with the exchange rate such that Cov(C1*,S1) = Corr(C1*,S1)Std(C1*)Std(S1) = (0.251)(39.8)($0.164/) = $1.64. Market conditions U.S. risk-free rate if = 2% U.S. required return i = 10% Spot and forward exchange rates Components of project value The value of the project at the forward exchange rate (ignoring operating exposure) V(F1) = [ E[C0*]S0 + E[C1*]F1/(1+i) ] = [ $150 + $150] = $0 The value of the managers exchange rate view E[S1] = F1(1+d1) = $1.65/ V(Forecast) = E[C1*]d1F1/(1+i) = (110)(0.10)($1.50/).(1.10) = $15 The value of the projects operating exposure to currency risk V(Covar) = Cov(C1*,S1)/(1+i) = ($1.64)/(1.10) = $1.49 Impact of a 100 percent forward hedge 1* of the expected cash flow E[C1*] V(Forecast|Hedge) = (E[C1*]1*)d1F1/(1+i) = (+110110)(0.10)($1.50/) = $0 Eq. (6): Projects perspective Spot exchange rate C0* = 100 E[C1*] = +110 Required return in pounds i* = 10% S0 = $100/ U.K. risk-free rate if* = 2% U.K. required return i* = 10% S0 = F1 = $1.50/

from Eq. (1)

V = S0V* = S0 E[C1*]/(1+i*) = ($1.50/)[(110/(1.10) 100)] = $0 Eq. (8) Parents perspective Spot and one-year forward exchange rate Managers exchange rate expectation C0* = 100 S0 = $1.50/ E[C1*] = +110 F1 = $1.50/ E[S1] = $1.65/

Required return in dollars i = 10% V = V(F1) + V(Forecast) + V(Covar) = $0 + $15 $1.49 = $13.51 Eq. (10) Project value from a U.S. perspective with a short forward hedge of 1* = 110 at F1 = $1.50/ that nets 1 = $165 in dollars Forward exchange rate short long $ E[C1*] = +110 1* = 110 1 = +$165 F1 = $1.50/ Required return in dollars i = 10% V(hedge) = V(Ft) + V(Forecast|Hedge) + V(Covar) = $0 + $0 $1.49 = $1.49

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Figure 3 The Decision to Hedge Currency Risk Unhedged project value Unhedged value is negative Reject the project This is likely to be a losing project regardless of whether it is hedged or not. Unhedged value is positive Ask why the hedged value of the project is positive The difference in value arises from the managers exchange rate forecast and from the projects operating exposure to currency risk. An ambiguous outcome a partial hedge reduces volatility but erodes value. Hedged the currency risk of the project with an appropriate financial market instrument Hedged value is positive If E[St] > Ft then hedge with relatively low-cost currency forwards. If E[St] < Ft then hedge with relatively low-cost foreign currency debt. Accept & structure the deal If V < V(Hedge), hedging yields higher value & lower risk. The firm should hedge. If V > V(Hedge), hedging yields lower value and lower risk. The hedging decision depends on managements confidence in their exchange rate forecast, the projects operating exposure to currency risk, and on the firms risk management policy.

Hedged value is negative

Hedged project value

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REFERENCES Abhyankar, A., L. Sarno, and G. Valente, 2005, Exchange Rates and Fundamentals: Evidence on the Economic Value of Predictability, Journal of International Economics 66, 325-348. Allayannis, G., and J.P. Weston, 2001, The Use of Foreign Currency Derivatives and Firm Market Value, Review of Financial Studies 14, 243-276. Bartram, S.M., 2007, Corporate Cash Flow and Stock Price Exposures to Foreign Exchange Rate Risk, Journal of Corporate Finance 13, 981-994. Bodnar, G.M., and M.H.F. Wong, F., 2003, Estimating Exchange Rate Exposures: Issues in Model Structure, Financial Management 32, 35-67. Chinn, M.D., and G. Meredith, 2004. Monetary Policy and Long Horizon Uncovered Interest Parity. IMF Staff Papers 51, 409-430. Choi, J., and M. Richardson, 2010. The Volatility of the Firms Assets, AFA 2010 Meetings Paper. de Zwart, G., T. Markwat, L. Swinkels, and D. van Dijk, 2009, The Economic Value of Fundamental and Technical Information in Emerging Currency Markets, Journal of International Money and Finance 28, 581-604. DeMarzo, P.M., and D. Duffie, 1991, Corporate Financial Hedging with Proprietary Information, Journal of Economic Theory 53, 261-286. DeMarzo, P.M., and D. Duffie, 1995, Corporate Incentives for Hedging and Hedge Accounting, Review of Financial Studies 8, 743-771. Engel, C., 1996, The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence, Journal of Empirical Finance 3, 123-192. Froot, K.A., D.S. Scharfstein, and J.C. Stein, 1993, Risk Management: Coordinating Corporate Investment and Financing Policies, Journal of Finance 48, 16291658. Gczy, C.C., B.A. Minton, and C.M. Schrand, 2007, Taking a View: Corporate Speculation, Governance, and Compensation, Journal of Finance 62, 2405-2443. Jongen, R., W.F.C. Verschoor, and C.C.P. Wolff, 2008, Foreign Exchange Rate Expectations: Survey and Synthesis, Journal of Economic Surveys 22, 140-165. Menkhoff, L., and M.P. Taylor, 2007, The Obstinate Passion of Foreign Exchange Professionals: Technical Analysis, Journal of Economic Literature 45, 936-972. OBrien, T.J., 2004, Foreign Exchange and Cross-Border Valuation, Journal of Applied Corporate Finance 16, 147-154. Pojarliev, M., and R.A. Levich, 2008, Do Professional Currency Managers Beat the Benchmark? Financial Analysts Journal 64, 18-32. Servaes, H., A. Tamayo, and P. Tufano, 2009, The Theory and Practice of Corporate Risk Management, Journal of Applied Corporate Finance 21, No. 4, 60-78. Smithson, C., and B.J. Simkins, 2005, Does Risk Management Add Value? A Survey of the Evidence, Journal of Applied Corporate Finance 17, 8-17. Williamson, R., 2001, Exchange Rate Exposure and Competition: Evidence from the Automotive Industry, Journal of Financial Economics 59, 441-475.

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Detachable Appendix Not Intended for Publication

The Variance of a Hedged Cash Flow Note to the referee(s) and editor: This not-for-publication appendix shows that under reasonable conditions the variance of hedged cash flow will always be less than the variance of unhedged cash flow. Hedging thereby reduces the variability of project value. Suppose a parent corporation has an operating exposure at time t with an expected value E[Ct*]. Typically this will be a cash inflow (E[Ct*]>0), but could be an outflow for short durations. The parent firm hedges a proportion (0<1) of the expected cash flow such that the hedged amount t* = E[Ct*]. This hedge creates a contractual foreign currency cash flow t* that is offset by a domestic currency cash flow of some kind. For a forward contract, the offsetting cash flows are t = t*Ft = E[Ct*]Ft and t* = E[Ct*]. The parents hedged cash flow in its domestic currency consists of a contractual cash flow t = t*Ft and an uncertain cash flow (Ct*t*)St, where the terms t* and Ft are constants in this context. Consequently, t*Ft is a constant and Var(t* Ft) = Cov(t* Ft, Z) = 0 for a random variable Z. The hedged cash flow is Ct = Ct*St + t*Ft t*St = Ct*St + t*Ft t*St. The variance of hedged cash flow is Var(Ct(Hedge)) = Var(Ct*St + tFt + (t*)St ) = Var(Ct*St ) + Var(t*Ft) + Var(t*St) + 2Cov(Ct*St, t*Ft) + 2Cov(Ct*St,t*St ) + 2Cov(t*Ft,t*St ) = Var(Ct*St) + 0 + (t*)2 Var(St) + 0 + 2Cov(Ct*St,t*St) 0 = Var(Ct*St) + (t*)2Var(St) 2t* Cov(Ct*St,St) (A.1) The Cov(Ct*St,St) term at the right of Eq. (A.1) can be further reduced using the following identities for random variables A and B: Cov(A,B) = E[AB] E[A]E[B] E[AB] = E[A] E[B] + Cov(A,B) Var(B) = E[B ] E[B]
2 2

(A.2) (A.3) (A.4)

Applying Eqs (A.2) and (A.3) leads to Cov(Ct*St,St) = E[(Ct*St)(St)] E[Ct*St]E[St] = E[(Ct*)(St)2] E[St]E[Ct*St] = E[Ct*]E[(St)2] + Cov(Ct*,(St)2) E[St]E[Ct*St] (A.5)

If A and B are bivariate normal random variables, Steins Lemma states that Cov(A,f(B)) = E[f(B)]Cov(A,B) where f(B) is the first derivative of f(B). For the middle term in Eq. (A.5), Steins Lemma leads to Cov(Ct*,(St)2) = E[2St]Cov(Ct*,St) = 2 E[St]Cov(Ct*,St) (A.6)

Substituting Eq. (A.6) and the identity E[Ct*St] = E[Ct*]E[St] + Cov(Ct*,St) into Eq. (A.5) yields 16

Cov(Ct*St,St) = E[Ct*]E[(St)2] + 2E[St]Cov(Ct*,St) E[St]{E[Ct*]E[St]+Cov(Ct*,St)} = E[Ct*]E[(St)2] + E[St]Cov(Ct*,St) E[Ct*]E[St]2 = E[Ct*]{E[(St)2] E[St]2} + E[St]Cov(Ct*,St) = E[Ct*]Var(St) + E[St]Cov(Ct*,St) Substituting this into the rightmost term of Eq. (A.1) then yields Var(Ct(Hedge)) = Var(Ct*St) + (t*)2Var(St) 2t*{E[Ct*]Var(St) + E[St]Cov(Ct*,St)} = Var(Ct*St) (t*)2Var(St) 2t*E[St]Cov(Ct*,St) (A.8) (A.7)

The variance of the hedged cash flow, Var(Ct(Hedge)), is less than the unhedged variance Var(Ct) = Var(Ct*St) so long as 0 > (t*)2Var(St) 2t* E[St]Cov(Ct*,St) (A.9)

Note that the (t*)2Var(St) term is always positive. The 2t*E[St]Cov(Ct*,St) term also will be positive under reasonable circumstances. Consider a foreign project with an expected foreign currency cash inflow, so that the hedged amount t* = E[Ct*] is greater than zero. Foreign subsidiaries that import typically are positively exposed to the value of the foreign currency St, so that Cov(Ct*,St) > 0. The product t* E[St]Cov(Ct*,St) then includes three positive values and Eq. (A.9) would hold. Conversely, a foreign subsidiary that exports would expect cash outflows in their local currency so that the hedged amount t* < 0. These subsidiaries would tend to be negatively exposed to the spot rate St, so that Cov(Ct*,St) < 0. The product t*E[St]Cov(Ct*,St) then includes one positive value (E[St]) and two negative values, and Eq. (A.9) again would hold. Consequently, the variance of a hedged cash flow will be less than the variance of an unhedged cash flow under reasonable assumptions about the projects exchange rate exposures.

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