The Effect of Foreign Currency Hedging on the Probability of Financial Distress

Abstract

This paper investigates the effect of foreign currency hedging with derivatives on the probability of financial distress. I use Merton's (1974) option pricing 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 greater distance to default, and hence 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.

Keywords: Corporate hedging, Derivatives, Financial distress, Distance to default

JEL Classification: F30, G32, G33