Corporate Hedging and SpeculativeIncentives: Implications for Swap Market DefaultRisk

Abstract

This paper demonstrates a tradeoff between therisk-shifting and hedging incentives of firms andidentifies conditions under which each dominates. Afirm may have the incentive to hedge in amulti-period context, even if no such incentiveexists in a single-period one. Unrestricted accessto swaps in the presence of asymmetric informationabout firm type and the swapping motive would leadto unbounded speculation resulting in breakdowns inswap and debt markets. Price-based methods areunable to control this and market makers have torely upon additional exposure information or creditenhancement devices to preserve equilibrium.