Derivatives as Non-Redundant Instruments: Completing Markets and Slack Financial Constraints
Open AccessI study whether derivatives are redundant instruments in both asset pricing and corporate finance contexts. Prior literature, such as the work of Conrad (1989, 2013), suggests a potential role for financial derivatives to complete markets as a latent consequence of third and fourth order movements with respect to changes in the investment opportunity set. Through Fama-MacBeth cross-sectional regressions and portfolio sorts, I find evidence supporting this conjecture, in so far as selected asset pricing anomalies are only pervasive for securities in which there are no listed options. Moreover, this is not an observable result of the prior literature in the form of size, default risk, or more limited institutional ownership. The analogous theoretical framework for corporate finance, following the work of Smith and Stulz (1985), rejects the irrelevance proposition of Modigliani and Miller (1958) as it pertains to the redundancy of derivatives for firm hedging policy. Through several regression analyses, including novel regression discontinuity designs, I find evidence that firms substitute between access to finance and hedging through the use of swaps. The results imply a first order effect for the firm hedging policy on financing decisions. In my analysis for both asset pricing and corporate finance contexts, I find evidence that derivatives exhibit a material impact for both completing markets and generating slack in firm financial constraints, demonstrating the channels through which they are non-redundant instruments.
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