Implications of the Modigliani-Miller Theorem for Hedging

To understand why a firm like Intel would want to change its risk exposure, we must

first return to the Modigliani-Miller Theorem (see Chapter 14). This theorem states that

in the absence of taxes and other market frictions, the capital structure decision is irrel-

evant. In other words, financial decisions cannot create value for a firm unless they in

some way affect either the firm’s ability to operate its business or its incentives to invest

in the future.

The Modigliani-Miller Theorem was applied initially to the analysis of the firm’s

debt-equity choice. However, the theorem is really much more general and can be

applied to the analysis of all aspects of the firm’s financial strategy. This would include,

for example, a firm’s choice of borrowing at a fixed rate or a floating rate; issuing

bonds with promised payments denominated in British pounds or U.S. dollars; or issu-

ing bonds with payments linked to the price of oil or some other commodity. In all

cases, these choices affect firm values only when there are relevant market frictions

like taxes, transaction costs, and financial distress costs. The Modigliani-Miller

Theorem also applies to other financial contracts and instruments. Firms can benefit

from futures, forwards, and swap contracts, but only in the presence of these same

frictions.

The Modigliani-Miller Theorem can be proved by showing that individual investors

can use “homemade” leverage on their own accounts to undo or duplicate any lever-

age choice made by the firms they own. It is also possible to apply this theorem to

show that, in the absence of market frictions, shareholders are indifferent between

hedging on their own accounts and having their firms do the hedging for them. For

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742Part VIRisk Management

example, given frictionless markets, shareholders realize identical returns if Intel

hedges its exposure to changes in the U.S. dollar-Euro exchange rate or if, alterna-

tively, Intel chooses not to hedge and the shareholders do the hedging in their per-

sonal accounts. In other words, investors can form portfolios with the same factor risk

and the same expected returns regardless of how firms hedge. As a result, in friction-

less markets where the operations side of the firm are held fixed, investors gain noth-

ing from the hedging choices of the firm.

Result 21.1

If hedging choices do not affect cash flows from real assets, then, in the absence of taxesand transaction costs, hedging decisions do not affect firm values.

Relaxing the Modigliani-Miller Assumptions

To understand why firms hedge, we must reevaluate the assumptions underlying the

Modigliani-Miller Theorem and ask which assumptions are likely to be unrealistic. Our

method for understanding why firms hedge is thus similar to the method employed in

Chapters 14 through 19 to understand the firm’s capital structure choice, and we draw

heavily from the analysis in those chapters.

The assumptions of the theorem imply that investors as well as corporations have

access to hedging instruments with no transaction costs. In reality, corporations are

often in a much better position to hedge certain risks than their shareholders. For exam-

ple, most institutional and individual investors would find it costly to learn how to

hedge a food company’s exposure to changes in the price of palm oil even though mar-

kets for such hedging instruments exist. In addition, corporate executives are much

more knowledgeable than shareholders about their firm’s risk exposures and thus are

in a better position to know how much to hedge.³

Nevertheless, the difficulties faced by shareholders who wish to hedge their port-

folio are probably not a prime reason or motivation for why large firms, owned pri-

marily by diversified investors, choose to hedge. Although these difficult-to-hedge

risks may affect the volatilities of individual stocks, most volatility is diversified

away in large portfolios.⁴Thus, hedging is unlikely to reduce a firm’s cost of capital

significantly. If hedging cannot reduce the discount rate a firm applies to value its

cash flows, then hedging must increase expected cash flows if it is to improve the

firm’s value.

Result 21.2

Hedging is unlikely to improve a firm’s value if it does no more than reduce the varianceof its future cash flows. To improve a firm’s value, hedging also must increase expectedcash flows.

³The fact that investors may not have the same access that corporations have to forward and futures

markets is sometimes offered as a rationale for why firms often do not hedge and sometimes speculate.

For example, most oil firms are very sensitive to oil price changes, yet hedge very little of that risk. One

rationale for this is that the forward and futures prices of oil are generally too low, making the cost of

hedging too high for the corporations. In a Modigliani and Miller world, the futures and forward prices

are irrelevant because investors are indifferent between having the oil companies take the oil price risk

and having the investors take the oil price risk directly by buying the oil price forwards and futures

(which, in this case, the firms would be selling). However, in reality, most investors are unable to invest

directly in oil forward and futures contracts, implying that the only way that these investors can buy

exposure to oil is to buy stocks in oil firms that choose not to hedge.

⁴Although hedging nondiversifiable risks, like interest rate movements, can affect a firm’s cost of

capital, it should still have no effect on the firm’s value. In this case, the reduction in the cost of capital

should be offset exactly by the effect of the hedge on cash flows.

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Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

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