Corporate Hedging, Contract Rights, and Basis Risk

A hedging contract can be terminated by a counterparty when a firm experiences an event of default, such as a credit downgrade, covenant violation, or bankruptcy. We build the model and show that counterparties are more likely to exercise their termination rights when a firm performs poorly and owes them money, leaving the firm exposed to risk at the worst possible time. Although the termination right reduces the hedging cost, it is inefficient because the counterparty exercising it does not consider the externality imposed on the firm. As a result, firms may hedge less, particularly when bankruptcy costs are high, and are more likely to liquidate. Using detailed hedging data, we find that derivatives are terminated in 60% of default cases and that such terminations help explain low corporate hedging in distress. We also find support for model predictions.