Financial Institutions Center - Callable Bonds and Hedging potx

Financial

Institutions

Center

Callable Bonds and Hedging

by

Levent Güntay

N.R. Prabhala

Haluk Unal

02-13

The Wharton Financial Institutions Center

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to

the problems and opportunities facing the financial services industry in its search for

competitive excellence. The Center's research focuses on the issues related to managing risk

at the firm level as well as ways to improve productivity and performance.

The Center fosters the development of a community of faculty, visiting scholars and Ph.D.

candidates whose research interests complement and support the mission of the Center. The

Center works closely with industry executives and practitioners to ensure that its research is

informed by the operating realities and competitive demands facing industry participants as

they pursue competitive excellence.

Copies of the working papers summarized here are available from the Center. If you would

like to learn more about the Center or become a member of our research community, please

let us know of your interest.

Franklin Allen Richard J. Herring

Co-Director Co-Director

The Working Paper Series is made possible by a generous

grant from the Alfred P. Sloan Foundation

Callable Bonds and Hedging

Levent G¸ntay

R. H. Smith School of Business

University of Maryland

College Park, MD 20742

(301) 345-1174

[email protected]

N. R. Prabhala

R. H. Smith School of Business

University of Maryland

College Park, MD 20742

(301) 405 2165

[email protected]

Haluk Unal ∗

R. H. Smith School of Business

University of Maryland

College Park, MD 20742

(301) 405 2265

[email protected]

First Version: August 2000

This Version: February 2002

Keywords: Hedging; Risk Management; Callable Bonds.

JEL Classifications: G30; G32.

∗Corresponding author. We thank many of our colleagues, and especially to Yiorgos Allayannis and Catherine

Schrand for extensive comments on an earlier draft.

Callable Bonds and Hedging

Abstract

We provide evidence that firms attach call options to debt issues to manage interest rate

risk. We show, using extensive time series data on these hedging transactions, that the hedging

decision is explained remarkably well by theories of hedging demand, such as the bankruptcy

and underinvestment explanations for why firms hedge. Our setting also leads to new and unique

evidence on the importance of the supply side in determining firmsí hedging strategies. Consistent

with this idea, we document that first time issuers in bond markets and small firms are more likely

to hedge using call options in bonds, contrary to virtually all received evidence that large firms

are more likely to hedge. The role of the supply side in hedging is further underlined by our

evidence of a secular and robust shift away from calls in the 1990s, a period of rapid growth and

increased availability of OTC derivatives.