Corporate Hedging, Contract Rights, and Basis Risk

75 Pages Posted: 2 Aug 2023 Last revised: 13 Jan 2025

See all articles by Ilona Babenko

Ilona Babenko

Arizona State University

Yuri Tserlukevich

Arizona State University (ASU)

Date Written: January 31, 2024

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. Our model shows that although the termination right reduces hedging costs, it can reduce firm value because the counterparty exercising it does not consider the externality imposed on the firm. Consequently, firms hedge less, especially 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 during financial distress.

Keywords: hedging, risk management, derivatives, event of default, distress, basis risk, ISDA, Master Agreement

JEL Classification: G30, G32

Suggested Citation

Babenko, Ilona and Tserlukevich, Yuri, Corporate Hedging, Contract Rights, and Basis Risk (January 31, 2024). HKU Jockey Club Enterprise Sustainability Global Research Institute - Archive, Available at SSRN: https://ssrn.com/abstract=4527523 or http://dx.doi.org/10.2139/ssrn.4527523

Ilona Babenko

Arizona State University ( email )

Department of Finance
W.P. Carey School of Business
Tempe, AZ 85287
United States

Yuri Tserlukevich (Contact Author)

Arizona State University (ASU) ( email )

Farmer Building 440G PO Box 872011
Tempe, AZ 85287
United States

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