Following a severe currency crisis in 1998, the Brazilian economy switched from a fixed to a floating exchange rate regime in 1999. Brazilian firms that had accumulated foreign currency liabilities in the fixed exchange rate regime suddenly found themselves exposed to significant currency risk. The temporary disequilibrium created by this shock allows us to trace the causal effect of currency hedging on corporate performance and firm value. We find that hedging allows a firm to insulate its capital expenditure from variation in operating cash flow. That is, it mitigates the underinvestment friction of Froot, Scharfstein and Stein (1993). Hedging also increases the foreign debt capacity of a firm at a time when domestic capital is scarce, allowing the firm to increase the level of investment. Both these channels lead to an improvement in the value of the firm.
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