FX hedging and creditor rights

The paper draws on Mohanty and Sundaresan (2018) to explore the effects of bankruptcy laws on the ex ante incentive for firms to hedge FX exposures. We use a simple model in which the bankruptcy code may result in deadweight losses, and may allow equity holders a share of residual value of the firm’s assets in the bankruptcy proceedings. The paper predicts that, while value-maximising firms promise to hedge a higher fraction of the value of their FX exposure when the debt is issued, they may renege subsequently and take on some FX exposures at the expense of foreign creditors. To preclude this, strong and enforceable loan/bond covenants must be in place. Furthermore, the model predicts that FX exposure affects credit spreads, and that thin FX hedging markets lead to greater FX exposure, and a higher probability of default. The paper tests these theoretical predictions and shows that unhedged corporate FX exposures at the country level are indeed negatively associated with the strength of creditor rights and the depth of hedging markets. Using loan-specific data from the Reserve Bank of India, and exploiting recent changes in the bankruptcy law, the paper uncovers a clear connection between the creditor rights and the hedging behaviour of non-financial firms.