Exchange rates, optimal debt composition, and hedging in small open economies
This paper develops a model of the firm's choice between debt denominated in local currency and that denominated in foreign currency in a small open economy characterized by exchange rate risk and hedging possibilities. The model shows that the currency composition of debt and the level of hedging are endogenously determined as optimal firms' responses to a tradeoff between the lower cost of borrowing in foreign debt and the higher risk of such borrowing due to exchange rate uncertainty. Both the composition of debt and the level of hedging depend on common factors such as foreign exchange rate risk and the probability of financial default, interest rates, the size of firms' net worth, and the costs of managing exchange rate risk. Results of the model are broadly consistent with the lending and hedging behavior of the corporate sector in small open economies that recently experienced currency crises. In particular, unlike the predictions of previous work in the literature on currency crises, the model can explain why the collapse of the fixed exchange rate regime in Brazil, in early 1999, caused no major change in the currency composition of debt of the corporate sector.
|Date of creation:||2008|
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- Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2004.
"A corporate balance-sheet approach to currency crises,"
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- Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2001. "A Corporate Balance Sheet Approach to Currency Crises," CEPR Discussion Papers 3092, C.E.P.R. Discussion Papers.
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- George Allayannis & Gregory W. Brown & Leora F. Klapper, 2003. "Capital Structure and Financial Risk: Evidence from Foreign Debt Use in East Asia," Journal of Finance, American Finance Association, vol. 58(6), pages 2667-2710, December.
- Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December.
- Martinez, Lorenza & Werner, Alejandro, 2002. "The exchange rate regime and the currency composition of corporate debt: the Mexican experience," Journal of Development Economics, Elsevier, vol. 69(2), pages 315-334, December. Full references (including those not matched with items on IDEAS)
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