Do Firms Hedge During Distress?
57 Pages Posted: 10 Jun 2019 Last revised: 26 May 2020
Date Written: May 16, 2020
Firms are less likely to use financial derivatives as they approach distress, even though theory predicts risk management is more valuable in these situations. By expanding the definition of hedging to include purchase obligations (POs) - non-cancelable forward contracts with suppliers – we are able to understand how firms hedge and whether hedging matters. We provide the first evidence that firms rely on POs during distress, often switching from derivatives to these contracts. Firms also initiate POs in response to liquidity shocks. Moreover, compared to hedging with derivatives, hedging with POs enables higher investment levels during times of financial distress. Firms adjust – but do not cease - hedging near distress and this mitigates underinvestment.
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