Given that it is costly, the widespread use of foreign exchange hedging is puzzling for several reasons. In an efficient market exchange rate fluctuations should even out over time. Also, exchange rate risk is generally regarded as unsystematic, and even if it is systematic investors can themselves hedge the risk. This paper answers the question of why firms hedge foreign exchange risk by invoking three agency problems. Given the existence of any of these agency problems, foreign exchange hedging does not merely impact firm risk. By smoothing cash‐flow streams, it also impacts directly firm value.
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