Signaling with Debt Currency Choice

Firms often expose themselves to currency risk by borrowing in foreign currencies, even when the local currency actually provides a better hedge in downturns. Motivated by this novel fact, we develop an international corporate finance model in which firms facing adverse selection choose the foreign currency share of their debt. In the unique separating equilibrium, good firms optimally expose themselves to currency risk to signal their type. Crucially, the nature of this equilibrium depends on the co-movement between cash flows and the exchange rate. We provide evidence consistent with the predictions of the model using a granular dataset including more than 4800 firms in 19 emerging markets and 5700 firms in 22 advanced economies between 2005 and 2021. The signaling mechanism is most salient for firms in emerging markets and also those subject to greater information asymmetries in advanced economies. These findings are important for assessing and managing risks from currency mismatches on corporate balance sheets.