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 its incentives to engage in efficient 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.
Journal of Finance. Forthcoming.