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The effect of foreign currency hedging on the probability of financial distress

Authors


  • I thank Don Adams, Phil Dolan, Robert Faff (the Editor), Doug Foster, Elizabeth Sheedy, Tom Smith, Garry Twite, an anonymous referee, and seminar participants at the Australian National University, Macquarie University and the 2008 Accounting and Finance Association of Australia and New Zealand Conference for their helpful comments and suggestions. Financial support from the Macquarie University Applied Finance Centre is gratefully acknowledged. All remaining errors are mine.

Abstract

This paper investigates the effect of foreign currency hedging with derivatives on the probability of financial distress. I use Merton’s (1974) structural default model to compute firms’ distance to default as a proxy for their probability of financial distress. Using an instrumental variables approach to control for endogenous hedging and leverage, I find that the extent of foreign currency hedging is associated with a lower probability of financial distress. Whereas previous research finds that the probability of financial distress is a determinant of a firm’s hedging policy, this paper provides direct evidence supporting the hypothesis that the extent of hedging reduces a firm’s probability of financial distress.

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