Managing corporate FX risk: A value-maximizing approach

Minimizing the probability of business disruption is presented as an object ive for FX hedging programs. Within this context firms hedge when the benef its, defined as the reduction in the expected costs of business disruption, exceed the expected costs. This policy is value-maximizing for the firm. M inimization of the variance of hedged operating cash flows, the usual appro ach, is an insufficient condition for minimizing the probability of busines s disruption within a predetermined period of time. In addition to the vari ance of hedged cash flows, two additional variables are important: 1) the r atio 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 t o be important in the empirical literature that examines motivations for he dging.