Explain a Firm's Hedging Exposure to Credit Rate Changes

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The Answer is In general,a firm would like to limit its exposure to changes in its own credit rating,since lenders almost always require larger default spreads when firms can least afford to pay the higher interest rates.Hence,firms tend to prefer financing alternatives that keep their default spreads fixed,such as long-term fixed-rate loans or floating-rate loans.However,two factors offset this preference.The first factor arises when there is disagreement about the firm's true financial condition.For example,the lender might believe that the firm will face financial difficulties in the future,but the borrower believes that its credit rating is likely to improve in the future.In this case,the borrower may not want to lock in what it considers an unfavourable default spread,preferring instead to borrow short term in the hope that its credit rating will improve in the future.The second factor arises because of the conflicts between debt holders and equity holders.A lender who is concerned that the firm will take on excessively risky investments is not willing to provide long-term financing on favourable terms.Both of these factors imply that the firm may borrow short term,taking on greater exposure to changes in its own credit rating than it would otherwise want,because the costs associated with long-term debt are simply too high.

Explain a Firm's Hedging Exposure to Credit Rate Changes

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