Financial Distress, Risk Shifting, and the Use of Options

Abstract

Risk shifting behaviour is central to corporate finance theory yet has not been vindicated by empirical research. We show that firms construct their derivative portfolios in ways that support the risk shifting hypothesis. Using hand-collected data from the oil and gas industry we find that financially distressed firms engage more frequently in the three-way collar strategy, and that the usage of this strategy increases following an exogenous increase in the probability of default. The three-way collar involves selling put options (i.e. selling insurance) to generate a cash inflow at inception, which preserves more upside for shareholders but increases downside risk for creditors. While banks monitor the risk of asset substitution effectively our findings suggest that risk-shifting through short derivative contracts (i.e. liability substitution) evades the monitoring of lenders.