Yuri Tserlukevich's webpage

Corporate Hedging, Contract Rights, and Basis Risk

Abstract:
A hedging contract can be terminated by a counterparty following a firm’s event of default, such as a credit downgrade, covenant violation, or bankruptcy. This right is often exercised in practice. Our model shows that although the termination right makes hedging cheaper for the firm, it reduces firm value because the counterparty exercising it does not consider the externality imposed on the firm. Consequently, firms may hedge less, even when facing high bankruptcy costs, and are more likely to enter liquidation. Using detailed hedging data, we confirm the model’s predictions and provide an explanation for low hedging in financial distress.