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​Economic Growth Centre Seminar | The Effects of Derivative Use on the Probability of Financial Stress

Published on: 11-Dec-2018

EventThe Effects of Derivative Use on the Probability of Financial Stress
Dr Amrit Judge
Associate Professor of Finance
Director of MBA Programme
Nottingham University Business School
Date11 December 2018 (Tuesday)
VenueHSS Meeting Room 4 (HSS-04-71)
Time11:00am – 12:30pm

This paper examines the effects of corporate derivative use on the probability of financial distress. We do so by constructing a unique and very detailed hand-collected dataset of UK non-financial firms’ derivative use during the period 1999-2000. Our results show that use of derivatives is associated with a reduction in the probability of default for our sample firms and that most of the reduction in the likelihood of default is generated in the first year of derivative use. We find that interest rate derivative use has a greater impact on the probability of default than foreign currency derivative use. Furthermore, hedging with derivatives has a significantly larger impact on near term default than long-term default probabilities, consistent with the notion that derivatives are better suited to manage short term rather than long-term financial price risks. Using several measures of aggregate credit risk conditions we show that the magnitude of the difference in default probabilities between derivatives users and non-users widens during periods of heightened economy-wide credit risk and is dampened in periods of low economy-wide credit risk, suggesting that firms are managing default risk when it matters most. We also find evidence consistent with speculation. Our results show that the use of derivatives by large firms increase the probability of default relative to all derivative users and non-users. Furthermore, we find that firms with higher pre-derivative default risk generate larger reductions in the likelihood of default from using derivatives, suggesting that those firms expected to benefit most from derivatives use are the ones doing so. In subsequent analysis, we find that the use of interest rate swaps in general can lead to the reduction of default probability. However, we find that large firms that swap into floating rate debt increase their default risk. Finally, we show that the use of derivatives lowers the cost of bank syndicated debt and in doing so increases firm value. 

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