Financial Distress and Corporate Risk Management: Theory & Evidence

Abstract:     
This paper extends the current theoretical models of corporate risk-management in the presence of financial distress costs and tests the model's predictions using a comprehensive dataset. I show that the shareholders optimally engage in ex-post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts a positive relation between leverage and hedging for moderately leveraged firms, which reverses for highly leveraged firms. Consistent with the theory, empirically I find a non-monotonic relation between leverage and hedging. Further, the effect of leverage on hedging is higher for firms in highly concentrated industries.

Keywords: Hedging, financial distress, risk-shifting, derivatives

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