Financial Distress, Risk Shifting, and the Use of Options

37 Pages Posted: 17 Jan 2018 Last revised: 18 Jan 2018

See all articles by Håkan Jankensgård

Håkan Jankensgård

Lund University - Department of Business Administration; Knut Wicksell Centre for Financial Studies

Niclas Andrén

Lund University - Department of Business Administration

Date Written: January 11, 2018

Abstract

Risk shifting behaviour is central to corporate finance theory yet has not been vindicated by empirical research. We show that firms construct their derivative portfolios in ways that support the risk shifting hypothesis. Using hand-collected data from the oil and gas industry we find that financially distressed firms engage more frequently in the three-way collar strategy, and that the usage of this strategy increases following an exogenous increase in the probability of default. The three-way collar involves selling put options (i.e. selling insurance) to generate a cash inflow at inception, which preserves more upside for shareholders but increases downside risk for creditors. While banks monitor the risk of asset substitution effectively our findings suggest that risk-shifting through short derivative contracts (i.e. liability substitution) evades the monitoring of lenders.

Keywords: corporate hedging, risk shifting, financial distress, risk management, financial constraints

JEL Classification: G30, G32

Suggested Citation

Jankensgård, Håkan and Andrén, Niclas, Financial Distress, Risk Shifting, and the Use of Options (January 11, 2018). Available at SSRN: https://ssrn.com/abstract=3100009 or http://dx.doi.org/10.2139/ssrn.3100009

Håkan Jankensgård (Contact Author)

Lund University - Department of Business Administration ( email )

Box 117
SE-221 00 Lund, S-220 07
Sweden

Knut Wicksell Centre for Financial Studies ( email )

Box 7080
Lund, SE-220 07
Sweden

Niclas Andrén

Lund University - Department of Business Administration ( email )

Box 117
SE-221 00 Lund, S-220 07
Sweden

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