FiRRM

Do Firms hedge in order to avoid financial distress costs? New empirical evidence using bank data.

We present a new approach to test the financial distress costs theory of corporate hedging empirically. We estimate the ex ante expected financial distress costs, which serve as a starting point to construct further explanatory variables in an equilibrium setting, as a fraction of the value of an asset‐or‐nothing put option on the firm's assets. Using single‐contract data of the derivatives' use of 189 German middle‐market companies that stems from a major bank as well as Basel II default probabilities and historical accounting information, we are able to explain a significant share of the observed cross‐sectional differences in hedge ratios. Hence, our analysis adds further support for the financial distress costs theory of corporate hedging from the perspective of a financial intermediary.