For the midterm project of Financial Institutions' Risk Management and Financial Management.

1. 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

2. !
Hedge, or Die !“
”

3. Hedging or Market Timing ?
Derivatives

5. Hedging or Market Timing ?
Derivatives

6. 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))

7. 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))

8. Speculation or Myopia,
Not Hedging Consideration !
Michael Faulkender (2005)
“
”

9. 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.

10. Agenda
2
3
4
1 Literature Review
Empirical Strategy
Data & Statistics Summary
Empirical Finding I
Empirical Finding II

11. Literature Review
1

12. 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 earning
less volatile. (Smith & Stulz, 1985)
➜ What hedging reduce the volatility of compensation is beneficial for
shareholders. (Stulz, 1984)
1
Hedging’s Development

13. 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

14. 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

15. 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))

16. 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.)

17. Empirical Strategy
Data & Statistic Summary
2

18. 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

19. 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

20. 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

21. 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

22. 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

23. 2.2 Data and Summary Statistics
Bank%loan%%%Bond%Issues
32%%%%%<%%%%%%%%68%%

24. Data and Summary Statistics2.2
Bank%loan%%%%%%%%Bond%Issues
↓%%%%%%%%%%%%%%%%%%%%%%%↓
Floating%rate%%%%%Fixed%rate
floating fixed
Bank.loans 71% 29%
Bond.Issues 13% 87%
Final&Exposure

25. Data and Summary Statistics2.2
Small%firm%%%%%%%%Large%firm%
↓%%%%%%%%%%%%%%%%%%%%%%%↓
Bank%loans%%%%%%%%Bond%Issues

26. Data and Summary Statistics2.2
Floating)– Fixed)rate
Larger&difference&in&the&yield&spread
→ Debt&exposure&that&ends&up
floating&are&issued
Significant!

27. Data and Summary Statistics2.2

28. Empirical Finding I
3.1
Determinants of
The Final Interest Rate Exposure

29. Determinants of
The Final Interest Rate Exposure
3.1
Yi = Free Cash Flow Beta
+ Market Timing
+ Control Variable
Yi = 1 If final exposure of the debt is floating
Yi = 0 if final exposure of the debt is fixed

30. Free Cash Flow Beta3.1
◇ Expectation:
- hedging ➜ positive
- Match the exposure of their assets and liabilities
Cash flow(asset) vs Newly issue debt

31. 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

32. Free Cash Flow Beta3.1
Alternative*measure*of*cash*flow
Not hedge

33. 3.1 Yield Spread
Prefer floating when
yield spread is high
(steep yield curve)

34. Yield Spread3.1
Prefer floating
➜ Steep yield curve
➜ Boom
Prefer fixed
➜ Flat yield curve
➜ Recession

35. 3.1 Control Variable
Less profitable firm
prefer less
expensive (floating)
rate debt

36. 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

37. 3.1 Percentage Current Exposure
Continue their
action before
(time the market)

38. 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

39. 3.1 Tobit regression Average'version

40. 3.1 Tobit regression
Not$hedge
significant

41. Empirical Finding I
3.2
Interpretation of the
Yield Spread Result

42. 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

43. Time-varying risk premium3.2
- Compensation paid to take on
interest rate risk
- Ex: Return forecasting factor
- Expectation:
- Significant

44. Time-varying risk premium3.2
Interest'rate'exposure'isn’t&driven&by'
change'in'premium (firm6specific'risk)

45. Cost of interest rate risk3.2
Macroeconomic Conditions
Measure1 : Index of Leading Economic Indicator
Measure2 : Chemical Production Index
Expectation:
both positive significant

46. Cost of interest rate risk3.2
Firms&manage&macroeconomic)&)industry)risk,&&&
rather&than&firm2specific)risk

47. Empirical Finding
4.1
Rubustness Checks

48. Table VI. Level of Interest Rates
versus Yield Spread
4.1
◇ 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.

49. 4.1
Yield&spread&=&10.year&treasury&yield&– 1.year&treasury&yield
Rubustness Checks

50. 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

51. 4.1 Rubustness Checks

52. Empirical Finding
4.2
Decomposing the Final Exposure

53. 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

54. 4.2 Decomposing the Final Exposure
Recall Table 1

55. (1)$Source$of$
Funds$
=$!
1#,%&'(
0,*. ,
(2)$Initial$
Exposure
=$!
1#,-.*&/0'1
0,-0234
(3)$Initial$Exposure
=$
5
1#,-0234# → -.*&/0'1
−1,-.*&/0'1 → -0234
0,*.,.

56. Conclusion
4.3

57. 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

58. Thanks for your attention.