Exchange Rate Regime and Financing Policies of the Corporate Sector in Small Open Economies.

This dissertation studies the relationship between exchange rate regimes and financing decisions of corporations in small open economies with access to international capital markets.The first essay develops a model of the choice between local and foreign currency debt by capital-constrained firms facing exchange rate risk and hedging possibilities. The model shows that the currency composition of debt and the level of hedging are both endogenously determined as optimal firms' responses to a tradeoff betweenthe lower cost of borrowing in foreign currency and the higher risk involved due to exchange rate uncertainty. The model explains why, unlike predictions of the previous work in the literature of currency crisis, the collapse of the fixed exchange rate regime in Brazil in early 1999 did not cause a major change in the currency composition of debt of the corporate sector.The second essay studies the effect of hedging with foreign currency derivatives on Brazilian firms in the period 1997 through 2004, a period that includes the Brazilian currency crisis in 1999. The paper finds that compared to non-user firms, derivative users have valuations that are 7-10% higher. Hedging with currency derivatives has three noticeable effects on firms: (i) it increases foreign debt capacity, so that there is a substitution from domestic debt to foreign debt, which is cheaper (ii) it removes the sensitivity of capital expenditures to Earnings Before Interest and Taxes (EBIT),and (III) it results in higher net income, for a given level of leverage and EBIT. It is argued that access to foreign debt represents a primary friction over the sample period, which makes hedging valuable.The third essay presents a case study to analyze hedging strategies implemented in practice by companies in Brazil. Two large companies, both operating in international markets and using financial hedging are chosen to illustrate how corporations deal with exchange rate risk. Consistent with corporate hedging theory, the case study finds that hedging contributes to smooth companies' earning and helpsmitigate the depletion of shareholder's equity. In turn, this contributes to reduce investor's risk perception about the firm and increases its foreign debt capacity.