Corporate Hedging, Contract Rights, and Basis Risk
75 Pages Posted: 2 Aug 2023 Last revised: 13 Jan 2025
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: Suggested Citation