ISDA highlights a selection of research papers on derivatives and risk management         

Currency Hedging: Managing Cash Flow Exposure

NBER Working Paper Series
By Laura Alfaro, Mauricio Calani, and Liliana Varela

This study analyzes the use of foreign exchange (FX) derivatives in Chile. In particular, the study focuses on firms’ currency risk exposures and their hedging choices.

The analysis is based on a dataset that includes over-the-counter FX derivatives, foreign currency debt, international trade (cash and trade credit on exports and imports) and employment data in Chile from 2005 to 2018.

The study shows that firms engaging in international trade and borrowing in foreign currency are significantly exposed to currency risk, as the use of natural hedging is limited. Natural hedging refers to a firm’s ability to match its payables and receivables in foreign currency.

The use of FX derivatives is primarily driven by larger firms that are more likely to hedge larger amounts. The analysis shows that companies tend to hedge foreign currency payables and receivables separately, instead of hedging a net position.

Using a policy reform that reduced the supply of US dollars forwards to firms in 2012 and 2013, the authors demonstrate that the liquidity of the FX derivatives market is a key determinant of companies’ hedging policies.

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US Dollar Currency Premium in Corporate Bonds

IMF Working Papers
By John Caramichael, Gita Gopinath and Gordon Y. Liao

The study compares the cost of borrowing in US dollar versus euro for global firms outside of the two currency regions and discusses several findings related to the US dollar currency premium.

The study finds that while US dollar dominates global debt issuance, dollar borrowing costs are more expensive without a currency hedge and are about the same with a currency hedge when compared to the euro.

The analysis observes a dollar safety premium for a subset of corporate bonds with high credit ratings and short maturities. For these bonds, the currency-hedged yield of US dollar bonds is typically lower than that of similar euro bonds.

The study also finds that global corporate borrowers flexibly adjust the currency mix of their debt issuance depending on the relative borrowing cost between dollar and euro debt.

The authors conclude that high demand for US dollar debt is reflected in higher issuance volumes that increase the currency-hedged dollar borrowing costs versus the level of euro borrowing costs.

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Climate Default Swap: Disentangling the Exposure to Transition Risk Through CDS

By Alexander Blasberg, Ruediger Kiesel, and Luca Taschini

The study measures the extent to which firms are exposed to the low-carbon transition risk and examines how this risk affects firms’ creditworthiness.

The authors use credit default swap (CDS) spreads and term structures of CDS spreads to evaluate the costs that firms may face due to changes in regulations, technology and consumers’ preferences related to the transition to a low-carbon economy, as well as the speed at which these costs could materialize.

The study demonstrates that the transition risk factor is a relevant determinant of CDS spread changes. The authors provide evidence of the relationship between the exposure to transition risk and firms’ cost of default protection. If investors perceive a company as unable to adapt to the low-carbon transition, this could significantly impact its ability to fulfill its financial obligations, ultimately affecting its creditworthiness.

The results show that markets perceive transition risk to have a significant impact on a
firm’s valuation. However, the transition risk impacts valuation differently depending on the company’s sector. Some carbon-intensive sectors, such as energy, exhibit an increase in default protection costs due to a higher perception of transition risk.

The study’s findings also suggest that investors are seeking greater protection against transition risks in the short to medium term, indicating an expectation of a swift transformation of the entire economic structure.

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