Well, the natural consequence of hedging is to reduce earnings volatility.

To illustrate this point, let's consider a firm facing the following situation.

The table on the right-hand side of this page outlines an exaggerated non-linear

tax function where higher and higher tax rates are charged against higher and

higher income levels.

The firm generating only $100,000 in taxable income, pays tax at only 8%.

Yet, a firm that owns $1 million, pays tax on total earnings at a rate of 80%.

It's highly exaggerated.

Now, let's consider two scenarios that the firm faces.

In the first, if it doesn't hedge, then it expects to earn $300,000

of income this year and $700,000 of income the year after.

So, that's one million dollars in total earnings over the two years.

The tax levied on $300,000 this year is $72,000.

And in the next, it'll be $392,000.

So the total tax liability over the two years will be $464,000.

In contrast, if the firm were to hedge, then it could completely smooth its

earnings, thereby generating $500,000 each year, or once again, $1 million in total.

Now, given the non-linear tax function that this firm faces,

the tax levied each year is only $200,000.

So, $400,000 in total.

Hence, the net effect of hedging when faced with the non-linear tax function is

a reduction in taxes paid from $464,000 to only $400,000.