Callable Bonds and Hedging

Levent Güntay, N. R. Prabhala and Haluk Unal

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: We provide evidence that firms attach call options to debt issues to manage interest rate risk. We show, using extensive time series data on these hedging transactions, that the hedging decision is explained remarkably well by theories of hedging demand, such as the bankruptcy and underinvestment explanations for why firms hedge. Our setting also leads to new and unique evidence on the importance of the supply side in determining firms’ hedging strategies. Consistent with this idea, we document that first time issuers in bond markets and small firms are more likely to hedge using call options in bonds, contrary to virtually all received evidence that large firms are more likely to hedge. The role of the supply side in hedging is further underlined by our evidence of a secular and robust shift away from calls in the 1990s, a period of rapid growth and increased availability of OTC derivatives.

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