Corporate Hedging, Contract Rights, and Basis Risk

Abstract:

The standard derivative contract may be terminated by the issuing counterparty when a firm experiences an ``event of default,'' such as a credit downgrade, non-payment, or bankruptcy filing. Counterparties often exercise such termination right and are more likely to do so if the firm owes them money, leaving the firm exposed to risk at the worst possible time. We build the theoretical model to examine the optimal hedging policy of a firm in the presence of the termination right. We show that early termination is inefficient in a sense that it benefits the counterparty exercising the right less than it hurts the firm. Further, higher bankruptcy costs can lead to less hedging with derivatives. Our results help explain why firms in distress reduce their derivative portfolios and why they shift to physical delivery contracts. Using hand-collected data and textual analysis, we find that the termination rights are exercised in 62% of default cases and that the key predictions of the model are supported by the data.