Explain Modigliani and Miller's argument that hedging is irrelevant. What are the most likely violations of Modigliani and Miller's assumptions in actual markets?

Question

What will be an ideal response?

Answer 1

Modigliani and Miller argued that a corporation's financial policies, such as issuing debt, hedging foreign exchange risk, and other purely financial risk management activities, do not change the value of the firm's assets unless these financial transactions lower the firm's taxes, affect its investment decisions, or can be done more cheaply than individual investors' transactions can be done.
The reason that reducing the uncertainty of future cash flows, per se, does not lead to a rationale for hedging is that it may not change investors' perceptions of the firm's systematic risk. We know from modern portfolio theory that the required rate of return on the equity cash flows of a corporation does not depend on the standard deviation of the firm's cash flows but only on the systematic risk associated with those cash flows. The fact that a firm's cash flows are uncertain is a necessary but not a sufficient condition for discounting the cash flows at a discount rate higher than the risk-free interest rate. Hence, unlike in the case of an entrepreneurial firm, if hedging merely reduces the unsystematic risk of the corporation's cash flows while leaving unchanged both the systematic risk and the expected value of the cash flows, hedging will not have any effect on the firm's value. Investors will still discount the same expected cash flows at the same required rate of return that is appropriate for the firm's systematic risk.
The assumptions of Modigliani and Miller are strong. The investment policy of the firm is probably not invariant to the hedging decisions of the firm because of the asymmetric information environment in which the firm operates. A primary argument for hedging is to assure the management of a sufficiently large internally generated cash flow so that the investment decisions of the firm are not affected by adverse fluctuations in exchange rates. Hedging also probably can reduce the taxes that a firm pays by shifting income from good states of the world in which the firm is profitable to bad states of the world in which the firm would otherwise be unprofitable.