Callable Bonds, Interest-Rate Risk, and the Supply Side of Hedging

Abstract

We show that firms attach call options to debt issues to manage interest-rate risk and characterize the empirical determinants of this hedging decision. Our results affirm that firms' hedging choices are explained by theories of hedging demand, but more importantly, provide novel evidence that the supply side of hedging is equally important. In contrast to studies based on OTC derivatives, small firms are more likely to hedge in our setting, in which supply-side barriers are absent. We show that there is a secular, robust shift away from callable bonds in the 1990s, when supply-side barriers to hedging declined. This shift is more likely when firms disclose derivatives usage disclosed in their 10-K's