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Finance Seminar

Author:

• Lukas Schmid
  Duke University

• Lorenzo Bretscher
  London School of Economics Finance and Political Science

• Philippe Mueller
  London School of Economics Finance and Political Science

• Andrea Vedolin
  London School of Economics Finance and Political Science

We provide novel empirical evidence on the determinants and effects of corporate interest rate risk management through swaps. Using a new, comprehensive hand collected data set on swap usage, we find that i) interest rate risk management significantly reduces expected default probabilities and credit spreads, ii) firms are on average floating rate payers, and iii) there are significant cross-sectional differences in swap usage according to asset and financing risk. In particular, using a variety of proxies for constraints and distress, we find that small and constrained firms hedge more, while distressed firms hedge little. These findings suggest substantial cross-sectional differences in the benefits of hedging. To quantify these benefits and to disentangle the effects of asset risk and financing risk on swap usage, we develop a dynamic model of corporate interest rate risk management in the presence of investment and financing frictions. We find that the endogenous cross-sectional distribution of firms in the model quantitatively rationalizes our empirical evidence. The model thus suggests that hedging interest rate risk creates value, especially for smaller and constrained firms.