Job Market Paper

This paper develops a model of the choice between local and foreign currency debt by firms facing exchange rate risk and hedging possibilities in small open economies. The model shows that the currency composition of debt and the optimal level of hedging are both endogenously determined as optimal firms’ responses to a tradeoff between the lower cost of borrowing in foreign debt and the higher risk involved due to exchange rate uncertainty. Both debt composition and hedging depend on common factors such as foreign exchange risk and financial default, interest rates, the size of net worth and costs of exchange rate risk management. Results of the model are broadly consistent with lending and hedging behavior of the corporate sector in small open economies recently hit by a currency crisis. In particular, the model is able to explain why, unlike predictions of previous work in the literature of currency crisis, the collapse of the fixed exchange rate regime in Brazil in early 1999 did not cause a major change in the currency composition of debt and the hedging behavior of the corporate sector