Explain the Implications of the Modigliani-Miller Theorem for Hedging

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The Answer is The Modigliani-Miller theorem states that,in the absence of taxes and other market frictions,the capital structure decision is irrelevant.In other words,financial decisions cannot create value for a firm unless they in some way affect either the firm's ability to operate its business or its incentives to invest in the future.The Modigliani-Miller Theorem was applied initially to the analysis of the firm's debt-equity choice.However,the theorem is really much more general,and can be applied to the analysis of all aspects of the firm's financial strategy.It also applies to other financial contracts and instruments.Firms can benefit from futures,forwards and swap contracts,but only in the presence of these same frictions.It is possible to apply this theorem to show that,in the absence of market frictions,shareholders are indifferent between hedging on their own accounts and having their firms do the hedging for them.Investors can form portfolios with the same factor risk and the same expected returns,regardless of how firms hedge.As a result,in frictionless markets where the operations side of the firm is held fixed,investors gain nothing from the hedging choices of the firm.

Explain the Implications of the Modigliani-Miller Theorem for Hedging

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