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Should Derivatives Be Privileged in Bankruptcy?
Author(s) -
BOLTON PATRICK,
OEHMKE MARTIN
Publication year - 2015
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12201
Subject(s) - seniority , derivative (finance) , bankruptcy , derivatives market , incentive , business , credit derivative , actuarial science , value (mathematics) , netting , finance , economics , credit risk , microeconomics , futures contract , computer science , machine learning , political science , law
Derivatives enjoy special status in bankruptcy: they are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate finance model to assess the effect of these exemptions on a firm's cost of borrowing and incentives to engage in derivative transactions. While derivatives are value‐enhancing risk management tools, seniority for derivatives can lead to inefficiencies: it transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross‐netting benefits to derivative counterparties that provide hedging services.