Derivatives Supply and Corporate Hedging: Evidence from the Safe Harbor Reform of 2005
Are supply-side fluctuations in the derivatives market important for corporate risk management? If the supply of hedging instruments is perfectly elastic, then hedging levels are determined exclusively by a company’s ‘demand’ for hedging. Evidence suggests, however, that the supply of hedging instruments is not frictionless. Survey evidence in Bodnar et al. (2013), for example, suggests that financial executives from around the world consider derivatives supply conditions to be important factors in corporate hedging decisions. Combined with the presence of hedging frictions, such as the risk of financial distress, these supply-side fluctuations can affect corporate hedging policies, as well as firm value and performance.
Empirically, establishing a causal link between supply frictions and corporate risk management is challenging because it requires an exogenous shock to derivatives supply. In this study, we exploit a regulatory change – introduced with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) – that significantly strengthened the protection granted to non-defaulting derivatives counterparties in bankruptcy, essentially allowing them to circumvent the Bankruptcy Code’s automatic stay and preference rules (Schwarcz and Sharon, 2013): the Safe Harbor Reform of 2005. As a result, the ‘supply’ of hedging instruments in favor of firms that could potentially face financial distress (eg, low Altman’s 1968 z-score firms) should increase.
Purnanandam (2008) develops a model in which optimal ex-post hedging is determined by a trade-off between the costs of financial distress and the benefits from risk shifting. This author shows that in a dynamic setting it is optimal for firms nearing financial distress to hedge ex-post (even without a pre-commitment to do so) because, by hedging, such firms stabilize their financial situation and, as a result, are able to preserve their market share. The predictions from this model are therefore that corporate hedging, firm value, and performance will increase for low-z-score firms (treated firms) relative to high-z-score firms (control firms) after the Safe Harbor Reform of 2005.
We start our analysis by focusing on scheduled airlines. Using a difference-in-difference approach, we find that fuel hedging for low-Z-score airlines (those that benefitted most from the 2005 reform) increased by 19.2 percentage points in the three years following the reform, compared to high-Z-score firms (control group) (Purnanadam, 2008). These findings pass a large number of robustness tests. To investigate the external validity of our findings, we also replicate all of our results from a large sample of non-financial firms from COMPUSTAT. Using a logit difference-in-difference approach, we find that the propensity to hedge for low-z-score firms (the treated group) increased by 8.3 percentage points in the three years following the reform relative to (otherwise similar) high-Z-score firms.
In line with Purnanadam (2008), we also find a significantly large increase in the value of low-Z-score airlines (treated firms) in the years after the 2005 reform. We likewise find that operating performance and passengers’ revenue increase significantly for low-Z-score airlines relative to control firms after 2005. We further find that the compensation of CFOs increases after the reform, suggesting that the beneficial effects of hedging on firm value and performance have positive consequences for executives’ compensation. We obtain very similar results for the general sample of non-financial firms.
Our findings can help inform the current policy debate on ‘derivatives margin requirements’. Uncollateralized derivatives are considered to have played an important role in the global financial crisis. In response, policymakers around the globe have adopted measures to limit access to derivatives products and increase financial markets stability (eg the Dodd-Frank Act of 2010 in the United States or the European Markets and Infrastructure Regulation of 2012 in Europe). Imposing more stringent margin requirements could limit the availability of hedging instruments to firms that are unable to post collateral. Ultimately, our article can help inform the current policy debate by highlighting the need to balance market stability with the consequences for corporate risk management and firm value that limiting hedging by imposing more stringent margin requirements might have.
The complete paper is available for download here.
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