Managing corporate FX risk: A value-maximizing approach

Minimizing the probability of business disruption is presented as an objective for FX hedging programs. Within this context firms hedge when the benefits, defined as the reduction in the expected costs of business disruption, exceed the expected costs. This policy is value-maximizing for the firm. Minimization of the variance of hedged operating cash flows, the usual approach, is an insufficient condition for minimizing the probability of business disruption within a predetermined period of time. In addition to the variance of hedged cash flows, two additional variables are important: 1) the ratio of operating cash inflows to cash outflows that represent the business disruption boundary-a coverage ratio, and 2) the reduction in the drift in operating cash flows caused by FX hedging costs. These factors are found to be important in the empirical literature that examines motivations for hedging.