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Corporate Hedging and Speculative Incentives: Implications for Swap Market Default Risk

Published online by Cambridge University Press:  06 April 2009

Abon Mozumdar
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Abstract

This paper demonstrates a tradeoff between the risk-shifting and hedging incentives of firms and identifies conditions under which each dominates. A firm may have the incentive to hedge in a multi-period context, even if no such incentive exists in a single-period one. Unrestricted access to swaps in the presence of asymmetric information about firm type and the swapping motive would lead to unbounded speculation resulting in breakdowns in swap and debt markets. Price-based methods are unable to control this and market makers have to rely upon additional exposure information or credit enhancement devices to preserve equilibrium.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 36 , Issue 2 , June 2001 , pp. 221 - 250
Copyright
Copyright © School of Business Administration, University of Washington 2001

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Footnotes

*

Pamplin College of Business, Virginia Tech, 1016 Pamplin Hall-0221, Blacksburg, VA 24061. This paper is based on a chapter entitled “Swaps, Default Risk and the Corporate Hedging Motive” from my Ph.D. dissertation at New York University. I am grateful to Hendrik Bessembinder (associate editor and referee) for exceptionally constructive comments, Jonathan Karpoff (the editor), Yakov Amihud, Don Chance, Zsuzsanna Fluck, Kose John, Authony Lynch, N. R. Prabhala, Anthony Saunders, Cliff Smith, Raghu Sundaram, Robert Whitelaw, and seminar participants at New York University and Virginia Tech for comments and suggestions. I especially thank Marti Subrahmanyam for guidance, suggestions, and encouragement. Financial support from a summer research grant at Virginia Tech is gratefully acknowledged. I am solely responsible for any remaining errors.

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