Do Firms Hedge in Order to Avoid Financial Distress Costs? New Empirical Evidence Using Bank Data
Posted: 13 Feb 2018 Last revised: 12 May 2020
Date Written: November 8, 2018
We present a new approach to test the financial distress costs (FDC) theory of corporate hedging empirically. We estimate the ex ante expected FDC, which serve as a starting point to construct further explanatory variables in an equilibrium setting, as a fraction of the value of an asset-or-nothing put option on the firm’s assets. Using single-contract data of the derivatives’ use of 189 German middle-market companies that stems from a major bank as well as Basel II default probabilities and historical accounting information, we are able to explain a significant share of the observed cross-sectional differences in hedge ratios.
Keywords: Corporate Hedging, Bankruptcy costs, Financial Distress, Derivatives
JEL Classification: G2, G32, G33, D81
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