Question

1. Exposure to interest rate or currency movements can add to the volatility of free cash flow. Would that add or subtract from the value of a firm? Why? If an increase in interest rates would be costly, how might management reduce that risk? If a rise in the value of the euro over the next six months would eliminate any profits from importing French wine, what might a U.S. wine importer do to avoid those losses?

Answer 1

The Interest rates or currency movements can add to the volatility of Cashflows as well as affect the value of firm. The firm's value can be affected in both ways depending on its exposure, For example. if interest rates increase, a firm which has investments in variable rate will gain more and a firm which has variable rate borrowings will suffer. Similarly, if a firm's receivables are in a currency which appreciates, the firm benefits , else it loses out.

This gain/losses also show their effect on the value of the firm

If an increase in interest rates are costly, a firm can undertake transactions in Interest linked derivative instruments  like Interest rate Futures (IRF) or Forward rate agreements (FRA) to hedge its risk

If Euro rises in value, the US importer may lose all its gains. To safeguard from such situation, the US importer can buy Euro in the futures/forward market (Forward hedge) or fix the Euro payables after six months using Money market hedge or can buy Euro call options to hedge its risk