Hedging or Market Timing ? Selecting Interest Rate Exposure of Corporate Debt

Michael Faulkender THE JOURNAL OF FINANCE • VOL. LX, NO. 2 • APRIL 2005

1st group 張博能/ 邱宇⾠辰/ 簡育昰/ 陳羿君

!Hedge, or Die !“

”

Hedging or Market Timing ?Derivatives

Hedging or Market Timing ?Derivatives

Hedging➜ The choice of the interest rate exposure of the firm’s liabilities should

be driven by the sensitivity of a firm’s cash flow to movements in interest rates. (Michael Faulkender (2005))

➜ Firms would try to reduce the variability of their cash flows. They ought to lower their expected costs of financial distress (Smith and Stulz (1985)), as well as minimize how often they have to raise expensive external capital (Froot, Scharfstein, and Stein (1993))

Market Timing➜ As the yield curve steepens, firms are more likely to take on floating-rate debt. (Michael Faulkender (2005))

➜ Firms those believe they could time the market can reduce their interest costs by “actively managing” their interest rate exposure as interest rates change. (Tufano (1995))

Speculation or Myopia,

Not Hedging Consideration ! Michael Faulkender (2005)

“”

Existing Related Works ➜ NOT explore the question of how firms achieve a particular exposure. (Michael

Faulkender (2005))

➜ Estimate the sources of value creation stemming from hedging by examining the cross-sectional variation in the use of derivatives by firms (see Nance, Smith, and Smithson (1993), Mian (1996), and Graham and Rogers (2002)).

➜ Interest rate hedging = borrow floating and swap to a fixed interest rate exposure.

Interest rate non-hedging = the fixed 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.

Agenda

2

3

4

1 Literature Review

Empirical StrategyData & Statistics Summary

Empirical Finding I

Empirical Finding II

Literature Review

1

Related Works of Hedging

➜ Financial Distress (Smith & Stulz,1985)➜ Debt capacity↑. Allow firm to capture tax shield (Leland, 1998)➜ External finance↑. Create a preference for internal cash over external borrowing (Myer and Majluf, 1984).➜ Hedging creates value. Positive NPV/ stable cash flow/ Fewer capital infusion. (Froot et al, 1993)➜ Reduce the expected tax payments by making their earningless volatile. (Smith & Stulz, 1985)➜ What hedging reduce the volatility of compensation is beneficial for shareholders. (Stulz, 1984)

1Hedging’s Development

Related Works of Hedging

➜ Early empirical examination shows use of derivatives equates their use with desire of firm hedging. (Michael Faulkender (2005))

➜ Some examine whether firms use derivatives(Mian (1996), Nance et al. (1993), and Geczy, Minton, and Schrand (1997)) , and examine their derivatives’ usage at the same time. (Berkman and Bradbury (1996), Gay and Nam (1999), Howton and Perfect (1999))

)

1

Derivative = Hedging

Related Works of Hedging1

➜ One critique of this line of research is the assumption that the

firms that do not use derivatives are not hedging (Thiagarajan

(2000) and Graham and Rogers (2002))

➜ may not face the derivative risk / use other methods.

➜ Whether taxes affect the extent of derivatives usage ? (Graham

and Rogers (2002))

Derivative != Hedging

Related Works of Market Timing1➜ Market timing responds to changes in macroeconomic

conditions, in an attempt to reduce their cost of capital. (Myers and Majluf (1984))

➜There exists evidence of firms’ market timing in equity market. (Baker and Wurgler (2000))

➜ Still, market timing effects exsist in debt markets as well. (Barclay and Smith (1995), Guedes and Opler (1996), Baker, Greenwood, and Wurgler (2003))

➜ 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 firm’s cost of capital. (Allayannis, Brown, and Klapper (2003))

Basic Idea➜ This methodology produces the final risk exposure. It makes possible an

analysis of how firms choose to arrive at this exposure.

➜ The variable of interest is the final interest rate exposure of newly issued debt instruments.

➜ Analyse time-series at monthly intervals, and not just examine cross-sectional variation

➜ The professor collects data on both bond issuances and bank loan originations, noting the initial interest rate exposure of the debt. (Interest rate swap’s information included.)

Empirical StrategyData & Statistic Summary

2

Empirical Strategy

If firms are hedging

➜ More positively exposed to interest rates

➜ Interest payments positively correlated with interest rates

2.1

Hedging the interest rate risk vs. Timing the market

2.1

Yield Spread ➜ The difference in the 10-year and 1-year yield(U.S. Treasury Bond)

Credit Spread ➜ The difference between the average Baa and Aaa corporate

bond(Moody’s)

The state of the economy ➜ Index of leading indicator

Industry strength ➜ Federal reserve board industrial production index

Empirical Strategy

Control Variables

{ Firm leverage

Potential costs of financial distress

Size

Profitability (Profit Margin)

R&D expenditure

Advertising expenditure

Capital expenditure{

2.1

{ Profit Margin

Sales

Empirical Strategy

Data and Summary Statistics2.2

◇ Regression Model(Cash Flow Beta)

Cash flowit /Book Assetsit = α + βCF,i(LIBORt) + εit

LIBORt

βCF,i

: Average 6-month LIBOR during quarter t

: Cash Flow Beta

Data and Summary Statistics2.2

◇ Data : Firms in the chemical industry

◇ Period : 1994 ~ 1999

◇ Source : SDC Platinum(Debt) DealScan(Bank loans) COMPUSTAT (Quarterly CF、

Annual Income statement、

Balance sheet)

➜ First year of SFAS119

➜ Large sample size➜ Rich heterogeneity in the interest rate exposure➜ The investment opportunities

◇ Sample: 275 debt issuances from 133 firms

2.2 Data and Summary Statistics

Bank%loan%%%Bond%Issues32%%%%%<%%%%%%%%68%%

Data and Summary Statistics2.2Bank%loan%%%%%%%%Bond%Issues

↓%%%%%%%%%%%%%%%%%%%%%%%↓Floating%rate%%%%%Fixed%rate

floating fixedBank.loans 71% 29%Bond.Issues 13% 87%

Final&Exposure

Data and Summary Statistics2.2

Small%firm%%%%%%%%Large%firm%↓%%%%%%%%%%%%%%%%%%%%%%%↓

Bank%loans%%%%%%%%Bond%Issues

Data and Summary Statistics2.2

Floating)– Fixed)rate

Larger&difference&in&the&yield&spread→ Debt&exposure&that&ends&up

floating&are&issued

Significant!

Data and Summary Statistics2.2

Empirical Finding I3.1

Determinants of The Final Interest Rate Exposure

Determinants of The Final Interest Rate Exposure3.1

Yi = Free Cash Flow Beta + Market Timing + Control Variable

Yi = 1 If final exposure of the debt is floatingYi = 0 if final exposure of the debt is fixed

Free Cash Flow Beta3.1

◇ Expectation:

- hedging ➜ positive

- Match the exposure of their assets and liabilities

Cash flow(asset) vs Newly issue debt

3.1 Free Cash Flow Beta

Interest rate sensitivity of firm’s cash flow

doesn’t predict whether

the firm chooses fixed of floating exposure on debts security

Free Cash Flow Beta3.1Alternative*measure*of*cash*flow

Not hedge

3.1 Yield Spread

Prefer floating when yield spread is high (steep yield curve)

Yield Spread3.1

Prefer floating

➜ Steep yield curve

➜ Boom

Prefer fixed

➜ Flat yield curve

➜ Recession

3.1 Control Variable

Less profitable firm prefer less expensive (floating) rate debt

Percentage Current Exposure3.1

- Only look at new issue, Ignore existing one

- Expectation

- hedging ➜ negative

- Managing their liability interest rate exposure

toward a long-term average

3.1 Percentage Current Exposure

Continue their action before (time the market)

Another way: Tobit regression3.1

- Regress the percentage of floating-rate debt on

the interest rate exposure of firm’s cash flow

- Tobit regression: dependent variable truncated

at zero and one

3.1 Tobit regression Average'version

3.1 Tobit regressionNot$hedge

significant

Empirical Finding I3.2

Interpretation of the Yield Spread Result

Decompose the Yield Spread3.2

Time-varying risk premium

Cost of interest rate risk

1

2

Premium high ➜ take risk ➜ floating

Recession➜ payment costly ➜ fixed

Time-varying risk premium3.2

- Compensation paid to take on

interest rate risk

- Ex: Return forecasting factor

- Expectation:

- Significant

Time-varying risk premium3.2

Interest'rate'exposure'isn’t&driven&by'change'in'premium (firm6specific'risk)

Cost of interest rate risk3.2

Macroeconomic ConditionsMeasure1 : Index of Leading Economic IndicatorMeasure2 : Chemical Production Index

Expectation: both positive significant

Cost of interest rate risk3.2

Firms&manage&macroeconomic)&)industry)risk,&&&rather&than&firm2specific)risk

Empirical Finding4.1

Rubustness Checks

Table VI. Level of Interest Rates versus Yield Spread4.1

◇ Expectation under hedging ◇ Empirical Findings

- The choice of yield’s exposure

is driven by the level of interest

rates.

- Floating ➜ high nominal level

- Fixed ➜ low

- Firms are responding to

the yield spread, not to

the level of interest rates.

4.1

Yield&spread&=&10.year&treasury&yield&– 1.year&treasury&yield

Rubustness Checks

Table VII. Yield Spread Effect, Conditional on Source and Amount

4.1

◇ Expectation under hedging ◇ Empirical Finding

- Different ability to manage risk ➜

different source of debt

- EX: bank: Smaller firms, more

risky(less able to endure interest

rate variability)

- Time the interest rate market

and to manage industry-wide

risk, not to hedge firm-

specific interest rate

exposure

- Swap cost are not too large

4.1 Rubustness Checks

Empirical Finding4.2

Decomposing the Final Exposure

Table VIII. Decomposition of final Exposure

4.2

- the source of funds is determined by the size of the firm and

credit ➜ not borrow capital from bank as size increases

- steepness of the term structure -> default interest rate exposure

of that source to be sufficiently costly

➜ { alter that exposure as part of

the debt contract

use swaps in order to achieve

their desired exposure

1

2

4.2 Decomposing the Final ExposureRecall Table 1

(1)$Source$of$Funds$

=$!1#,%&'(0,*. ,

(2)$Initial$Exposure

=$!1#,-.*&/0'10,-0234

(3)$Initial$Exposure=$

51#, -0234# → -.*&/0'1−1,-.*&/0'1 → -0234

0,*.,.

Conclusion4.3

Conclusion4.3

1 market timing not hedge

yield curve

The source of funds does not affect the responsiveness of firms to market timing variables.

Managing risk is not prohibitively complex or expensive

{ 𝑠𝑡𝑒𝑒𝑝→𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔

𝑓𝑙𝑎𝑡→𝑓𝑖𝑥𝑒𝑑

2

3

4

Thanks for your attention.