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Hedging or market timing? selecting the interest rate exposure of corporate debt
1. Hedging or Market Timing ? Selecting
Interest Rate Exposure of Corporate Debt
Michael Faulkender
THE JOURNAL OF FINANCE โข VOL. LX, NO. 2 โข APRIL 2005
1st group ๅผตๅ่ฝ/ ้ฑๅฎโพ ่พฐ/ ็ฐก่ฒๆฐ/ ้ณ็พฟๅ
6. Hedging
โ The choice of the interest rate exposure of the ๏ฌrmโs liabilities should
be driven by the sensitivity of a ๏ฌrmโs cash ๏ฌow to movements in
interest rates. (Michael Faulkender (2005))
โ Firms would try to reduce the variability of their cash ๏ฌows. They
ought to lower their expected costs of ๏ฌnancial distress (Smith and
Stulz (1985)), as well as minimize how often they have to raise
expensive external capital (Froot, Scharfstein, and Stein (1993))
7. Market Timing
โ As the yield curve steepens, ๏ฌrms are more likely to take on
๏ฌoating-rate debt. (Michael Faulkender (2005))
โ Firms those believe they could time the market can reduce
their interest costs by โactively managingโ their interest
rate exposure as interest rates change. (Tufano (1995))
9. Existing Related Works
โ NOT explore the question of how ๏ฌrms achieve a particular exposure. (Michael
Faulkender (2005))
โ Estimate the sources of value creation stemming from hedging by examining the
cross-sectional variation in the use of derivatives by ๏ฌrms (see Nance, Smith,
and Smithson (1993), Mian (1996), and Graham and Rogers (2002)).
โ Interest rate hedging = borrow ๏ฌoating and swap to a ๏ฌxed interest rate
exposure.
Interest rate non-hedging = the ๏ฌxed rate debt users that do not swap
(Mian (1996), Nance et al. (1993))
Firms may be managing their risks, especially interest rate risk, by means other
than derivatives usage.
12. Related Works of Hedging
โ Financial Distress (Smith & Stulz,1985)
โ Debt capacityโ. Allow ๏ฌrm to capture tax shield (Leland, 1998)
โ External ๏ฌnanceโ. Create a preference for internal cash over
external borrowing (Myer and Majluf, 1984).
โ Hedging creates value. Positive NPV/ stable cash ๏ฌow/
Fewer capital infusion. (Froot et al, 1993)
โ Reduce the expected tax payments by making their earning
less volatile. (Smith & Stulz, 1985)
โ What hedging reduce the volatility of compensation is bene๏ฌcial for
shareholders. (Stulz, 1984)
1
Hedgingโs Development
13. Related Works of Hedging
โ Early empirical examination shows use of derivatives equates
their use with desire of ๏ฌrm hedging. (Michael Faulkender (2005))
โ Some examine whether ๏ฌrms use derivatives(Mian (1996), Nance
et al. (1993), and Geczy, Minton, and Schrand (1997)) , and
examine their derivativesโ usage at the same time. (Berkman and
Bradbury (1996), Gay and Nam (1999), Howton and Perfect (1999))
)
1
Derivative = Hedging
14. Related Works of Hedging1
โ One critique of this line of research is the assumption that the
๏ฌrms that do not use derivatives are not hedging (Thiagarajan
(2000) and Graham and Rogers (2002))
โ may not face the derivative risk / use other methods.
โ Whether taxes affect the extent of derivatives usage ? (Graham
and Rogers (2002))
Derivative != Hedging
15. Related Works of Market Timing1
โ Market timing responds to changes in macroeconomic
conditions, in an attempt to reduce their cost of capital. (Myers
and Majluf (1984))
โThere exists evidence of ๏ฌrmsโ market timing in equity market.
(Baker and Wurgler (2000))
โ Still, market timing effects exsist in debt markets as well.
(Barclay and Smith (1995), Guedes and Opler (1996), Baker,
Greenwood, and Wurgler (2003))
โ Firms are more likely to borrow in a foreign currency as the
difference between LIBOR and local interest rates increases,
taking on currency risk in an attempt to reduce the ๏ฌrmโs cost of
capital. (Allayannis, Brown, and Klapper (2003))
16. Basic Idea
โ This methodology produces the ๏ฌnal risk exposure. It makes possible an
analysis of how ๏ฌrms choose to arrive at this exposure.
โ The variable of interest is the ๏ฌnal interest rate exposure of newly issued
debt instruments.
โ Analyse time-series at monthly intervals, and not just examine cross-
sectional variation
โ The professor collects data on both bond issuances and bank loan
originations, noting the initial interest rate exposure of the debt. (Interest rate
swapโs information included.)
18. Empirical Strategy
If ๏ฌrms are hedging
โ More positively exposed to interest rates
โ Interest payments positively correlated with interest rates
2.1
Hedging the interest rate risk vs. Timing the market
19. 2.1
Yield Spread
โ The difference in the 10-year and 1-year yield(U.S. Treasury Bond)
Credit Spread
โ The difference between the average Baa and Aaa corporate
bond(Moodyโs)
The state of the economy
โ Index of leading indicator
Industry strength
โ Federal reserve board industrial production index
Empirical Strategy
20. Control Variables
{
Firm leverage
Potential costs of ๏ฌnancial distress
Size
Pro๏ฌtability (Pro๏ฌt Margin)
R&D expenditure
Advertising expenditure
Capital expenditure
{
2.1
{
Pro๏ฌt Margin
Sales
Empirical Strategy
21. Data and Summary Statistics2.2
โ Regression Model(Cash Flow Beta)
Cash flowit /Book Assetsit = ฮฑ + ฮฒCF,i(LIBORt) + ฮตit
LIBORt
ฮฒCF,i
: Average 6-month LIBOR during quarter t
: Cash Flow Beta
22. Data and Summary Statistics2.2
โ Data : Firms in the chemical industry
โ Period : 1994 ~ 1999
โ Source : SDC Platinum(Debt)
DealScan(Bank loans)
COMPUSTAT (Quarterly CFใ
Annual Income statementใ
Balance sheet)
โ First year of SFAS119
โ Large sample size
โ Rich heterogeneity in the interest rate exposure
โ The investment opportunities
โ Sample: 275 debt issuances from 133 ๏ฌrms
23. 2.2 Data and Summary Statistics
Bank%loan%%%Bond%Issues
32%%%%%<%%%%%%%%68%%
24. Data and Summary Statistics2.2
Bank%loan%%%%%%%%Bond%Issues
โ%%%%%%%%%%%%%%%%%%%%%%%โ
Floating%rate%%%%%Fixed%rate
floating fixed
Bank.loans 71% 29%
Bond.Issues 13% 87%
Final&Exposure
25. Data and Summary Statistics2.2
Small%firm%%%%%%%%Large%firm%
โ%%%%%%%%%%%%%%%%%%%%%%%โ
Bank%loans%%%%%%%%Bond%Issues
26. Data and Summary Statistics2.2
Floating)โ Fixed)rate
Larger&difference&in&the&yield&spread
โ Debt&exposure&that&ends&up
floating&are&issued
Significant!
29. Determinants of
The Final Interest Rate Exposure
3.1
Yi = Free Cash Flow Beta
+ Market Timing
+ Control Variable
Yi = 1 If ๏ฌnal exposure of the debt is ๏ฌoating
Yi = 0 if ๏ฌnal exposure of the debt is ๏ฌxed
30. Free Cash Flow Beta3.1
โ Expectation:
- hedging โ positive
- Match the exposure of their assets and liabilities
Cash ๏ฌow(asset) vs Newly issue debt
31. 3.1 Free Cash Flow Beta
Interest rate sensitivity
of firmโs cash flow
doesnโt predict whether
the firm chooses fixed of
floating exposure on
debts security
32. Free Cash Flow Beta3.1
Alternative*measure*of*cash*flow
Not hedge
36. Percentage Current Exposure3.1
- Only look at new issue, Ignore existing one
- Expectation
- hedging โ negative
- Managing their liability interest rate exposure
toward a long-term average
38. Another way: Tobit regression3.1
- Regress the percentage of floating-rate debt on
the interest rate exposure of firmโs cash flow
- Tobit regression: dependent variable truncated
at zero and one
45. Cost of interest rate risk3.2
Macroeconomic Conditions
Measure1 : Index of Leading Economic Indicator
Measure2 : Chemical Production Index
Expectation:
both positive signi๏ฌcant
46. Cost of interest rate risk3.2
Firms&manage¯oeconomic)&)industry)risk,&&&
rather&than&firm2specific)risk
48. Table VI. Level of Interest Rates
versus Yield Spread
4.1
โ Expectation under hedging โ Empirical Findings
- The choice of yieldโs exposure
is driven by the level of interest
rates.
- Floating โ high nominal level
- Fixed โ low
- Firms are responding to
the yield spread, not to
the level of interest rates.
50. Table VII. Yield Spread Effect,
Conditional on Source and
Amount
4.1
โ Expectation under hedging โ Empirical Finding
- Different ability to manage risk โ
different source of debt
- EX: bank: Smaller ๏ฌrms, more
risky(less able to endure interest
rate variability)
- Time the interest rate market
and to manage industry-wide
risk, not to hedge ๏ฌrm-
speci๏ฌc interest rate
exposure
- Swap cost are not too large
53. Table VIII. Decomposition
of ๏ฌnal Exposure
4.2
- the source of funds is determined by the size of the ๏ฌrm and
credit โ not borrow capital from bank as size increases
- steepness of the term structure -> default interest rate exposure
of that source to be suf๏ฌciently costly
โ
{
alter that exposure as part of
the debt contract
use swaps in order to achieve
their desired exposure
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57. Conclusion4.3
1 market timing not hedge
yield curve
The source of funds does not affect the
responsiveness of ๏ฌrms to market timing variables.
Managing risk is not prohibitively
complex or expensive
{
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