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

Abon Mozumdar

Journal of Financial and Quantitative Analysis, 2001, vol. 36, issue 2, 221-250

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.

Date: 2001
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