The role of interest rate swaps in corporate finance

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Title: The Role of Interest Rate Swaps in Corporate Finance
Keywords: interest rate swaps, derivative instruments
Author: Anatoli Kuprianov
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The Role of Interest Rate
Swaps in Corporate Finance
Anatoli Kuprianov
n interest rate swap is a contractual agreement between two parties
to exchange a series of interest rate payments without exchanging the
underlying debt. The interest rate swap represents one example of a
Ageneral category of financial instruments known as derivative instruments. In
the most general terms, a derivative instrument is an agreement whose value
derives from some underlying market return, market price, or price index.
The rapid growth of the market for swaps and other derivatives in re-
cent years has spurred considerable controversy over the economic rationale
for these instruments. Many observers have expressed alarm over the growth
and size of the market, arguing that interest rate swaps and other derivative
instruments threaten the stability of financial markets. Recently, such fears
have led both legislators and bank regulators to consider measures to curb the
growth of the market. Several legislators have begun to promote initiatives
to create an entirely new regulatory agency to supervise derivatives trading
activity. Underlying these initiatives is the premise that derivative instruments
increase aggregate risk in the economy, either by encouraging speculation or by
burdening firms with risks that management does not understand fully and is
incapable of controlling.1 To be certain, much of this criticism is aimed at many
of the more exotic derivative instruments that have begun to appear recently.
Nevertheless, it is difficult, if not impossible, to appreciate the economic role
of these more exotic instruments without an understanding of the role of the
interest rate swap, the most basic of the new generation of financial derivatives.
The views expressed herein are those of the author and do not necessarily represent the
views of either the Federal Reserve Bank of Richmond or the Board of Governors of the
Federal Reserve System. The motivation for this article grew out of discussions with Douglas
Diamond. Michael Dotsey, Jeff Lacker, Roy Webb, and John Weinberg provided thoughtful
criticism and helpful comments.
1 For a review of these stated concerns, recent policy initiatives, and pending legislation, see
Cummins (1994a, 1994b), Karr (1994), and Rehm (1994).
Federal Reserve Bank of Richmond Economic Quarterly Volume 80/3 Summer 1994 49
50 Federal Reserve Bank of Richmond Economic Quarterly
Although the factors accounting for the remarkable growth of the swaps
market are yet to be fully understood, financial economists have proposed a
number of different hypotheses to explain how and why firms use interest rate
swaps. The early explanation, popular among market participants, was that
interest rate swaps lowered financing costs by making it possible for firms to
arbitrage the mispricing of credit risk. If this were the only rationale for interest
rate swaps, however, it would mean that these instruments exist only to facil-
itate a way around market inefficiencies and should become redundant once
arbitrage leads market participants to begin pricing credit risk correctly. Thus,
trading in interest rate swaps should die out over time as arbitrage opportunities
disappear--a prediction that is at odds with actual experience.
Other observers note that the advent of the interest rate swap coincided with
a period of extraordinary volatility in U.S. market interest rates, leading them
to attribute the rapid growth of interest rate derivatives to the desire on the part
of firms to hedge cash flows against the effects of interest rate volatility. The
timing of the appearance of interest rate swaps, coming as it did during a pe-
riod of volatile rates, seems to lend support to such arguments. Risk avoidance
alone cannot explain the growth of the swaps market, however, because firms
can always protect themselves against rising interest rates simply by taking
out fixed-rate, long-term loans or by bypassing credit markets altogether and
issuing equity to fund investments.
Recent research emphasizes that interest rate swaps offer firms new
financing choices that were just not available before the advent of these instru-
ments, and thus represent a true financial innovation. This research suggests
that the financing choices made available by interest rate swaps may help to
reduce default risk and may sometimes make it possible for firms to undertake
productive investments that would not be feasible otherwise. The discussion
that follows explains the basic mechanics of interest rate swaps and examines
these rationales in more detail.
1. FUNDAMENTALS OF INTEREST RATE SWAPS
The most common type of interest rate swap is the fixed/floating swap in
which a fixed-rate payer promises to make periodic payments based on a fixed
interest rate to a floating-rate payer, who in turn agrees to make variable pay-
ments indexed to some short-term interest rate. Conventionally, the parties to
the agreement are termed counterparties. The size of the payments exchanged
by the counterparties is based on some stipulated notional principal amount,
which itself is not paid or received.
Interest rate swaps are traded over the counter. The over-the-counter (OTC)
market is comprised of a group of dealers, consisting of major international
commercial and investment banks, who communicate offers to buy and sell
A. Kuprianov: The Role of Interest Rate Swaps 51
swaps over telecommunications networks. Swap dealers intermediate cash flows
between different customers, acting as middlemen for each transaction. These
dealers act as market makers who quote bid and asked prices at which they
stand ready to either buy or sell an interest rate swap before a customer for
the other half of the transaction can be found. (By convention, the fixed-rate
payer in an interest rate swap is termed the buyer, while the floating-rate payer
is termed the seller.) The quoted spread allows the dealer to receive a higher
payment from one counterparty than is paid to the other.
Because swap dealers act as intermediaries, a swap customer need be
concerned only with the financial condition of the dealer and not with the
creditworthiness of the other ultimate counterparty to the agreement. Counter-
party credit risk refers to the risk that a counterparty to an interest rate swap
will default when the agreement has value to the other party.2 Managing the
credit risk associated with swap transactions requires credit-evaluation skills
similar to those commonly associated with bank lending. As a result, commer-
cial banks, which have traditionally specialized in credit-risk evaluation and
have the capital reserves necessary to support credit-risk management, have
come to dominate the market for interest rate swaps (Smith, Smithson, and
Wakeman 1986).
The discussion that follows largely abstracts from counterparty credit risk
and the role of swap dealers. In addition, the description of interest rate swaps
is stylized and omits many market conventions and other details so as to focus
on the fundamental economic features of swap transactions. For a more de-
tailed description of interest rate swaps and other interest rate derivatives, see
Kuprianov (1993b). Burghardt et al. (1991) and Marshall and Kapner (1993)
provide more comprehensive treatments.
Mechanics of a Fixed/Floating Swap
The quoted price of an interest rate swap consists of two different interest rates.
In the case of a fixed/floating swap, the quoted interest rates involve a fixed and
a floating rate. The floating interest rate typically is indexed to some market-
determined rate such as the Treasury bill rate or, more commonly, the three-
or six-month London Interbank Offered Rate, or LIBOR.3 Such a swap is also
known as a generic, or plain-vanilla, swap.
The basic mechanics of a fixed/floating swap are relatively straightforward.
Consider an interest rate swap in which the parties to the agreement agree to
2 An increase in market interest rates, for example, increases the value of a swap agreement
to the fixed-rate payer, who will subsequently receive higher interest rate payments from the
floating-rate payer.
3 The London Interbank Offered Rate is the rate at which major international banks with
offices in London stand ready to accept deposits from one another. See Goodfriend (1993) or
Burghardt et al. (1991) for a detailed description of the Eurodollar market.
52 Federal Reserve Bank of Richmond Economic Quarterly
exchange payments at the end of each of T periods, indexed by the variable
t = 1, 2, . . . , T. Let rs denote the fixed rate and rs(t) denote the floating
interest rate on a fixed/floating swap. Payments between the fixed- and floating-
rate payers commonly are scheduled for the same dates, in which case only net
amounts owed are exchanged. The net cost of the swap to the fixed-rate payer
at the end of each period would be rs - rs(t) for each $1 of notional principal.
If the swap's fixed rate is greater than the variable rate at the end of a period
(i.e., rs > rs(t)), then the fixed-rate payer must pay the difference between
the fixed interest payment on the notional principal to the floating-rate payer.
Otherwise, the difference rs -rs(t) is negative, meaning that the fixed-rate payer
receives the difference from the floating-rate payer. The net cost of the swap
to the floating-rate payer is just the negative of this amount. For the sake of
notational convenience, the discussion that follows assumes that all swaps have
a notional principal of $1, unless otherwise noted.
Uses of Interest Rate Swaps--Synthetic Financing
Firms use interest rate swaps to change the effective maturity of interest-bearing
assets or liabilities. To illustrate, suppose a firm has short-term bank debt out-
standing. At the start of each period this firm refinances its debt at the prevailing
short-term interest rate, rb(t). If short-term market interest rates are volatile, then
the firm's financing costs will be volatile as well. By entering into an interest
rate swap, the firm can change its short-term floating-rate debt into a synthetic
fixed-rate obligation.
Suppose the firm enters into an interest rate swap as a fixed-rate payer. Its
resulting net payments in each period t = 1, 2, . . . , T of the agreement are
determined by adding the net payments required of a fixed-rate payer to the
cost of servicing its outstanding floating-rate debt.
Period t cost of servicing outstanding short-term debt rb(t)
+ Period t cost of interest rate swap payments rs - rs(t)
= Period t cost of synthetic fixed-rate financing rs + [rb(t) - rs(t)]
Thus, the net cost of the synthetic fixed-rate financing is determined by the
swap fixed rate plus the difference between its short-term borrowing rate and
the floating-rate index.
Banks often index the short-term loan rates they charge their corporate
customers to LIBOR. Suppose the firm in this example is able to borrow at
LIBOR plus a credit-quality risk premium, or credit-quality spread, q(t).
Suppose further that the swap's floating-rate index is LIBOR. Then,
rb(t) - rs(t) = [LIBOR(t) + q(t)] - LIBOR(t)
= q(t).
A. Kuprianov: The Role of Interest Rate Swaps 53
The period t cost of synthetic fixed-rate financing in this case is just rs + q(t),
the swap fixed rate plus the short-term credit-quality spread q(t).
Now consider the other side to this transaction. Suppose a firm with out-
standing fixed-rate debt on which it pays an interest rate of rb enters into a swap
as a floating-rate payer so as to convert its fixed-rate obligation to a synthetic
floating-rate note. The net period t cost of this synthetic note is just the cost of
its fixed-rate obligation plus the net cost of the swap:
Period t cost of synthetic floating rate note = rs(t) + (rb - rs).
The cost of synthetic floating-rate financing just equals the floating rate on the
interest rate swap plus the difference between the interest rate the firm pays
on its outstanding fixed-rate debt and the fixed interest rate it receives from its
swap counterparty.
Thus, interest rate swaps can be used to change the characteristics of a
firm's outstanding debt obligations. Using interest rate swaps, firms can change
floating-rate debt into synthetic fixed-rate financing or, alternatively, a fixed-
rate obligation into synthetic floating-rate financing. But these observations
raise an obvious question. Why would a firm issue short-term debt only to
swap its interest payments into a longer-term, fixed-rate obligation rather than
just issue long-term, fixed-rate debt at the outset? Conversely, why would a firm
issue long-term debt and swap it into synthetic floating-rate debt rather than
simply issuing floating-rate debt at the outset? The next two sections explore
the rationales that have been offered to explain the widespread use of interest
rate swaps.
2. INTEREST RATE SWAPS, ARBITRAGE, AND THE
THEORY OF COMPARATIVE ADVANTAGE
The rapid growth of the swaps market in recent years strongly suggests that
market participants must perceive significant benefits associated with the use of
such instruments. The rationale most frequently offered by market participants
is that interest rate swaps offer users an opportunity to reduce funding costs.4
Bicksler and Chen (1986) present what is perhaps the best-known exposition
of this viewpoint, which is based on the principle of comparative advantage.
In international trade theory, the principle of comparative advantage explains
the economic rationale for international trade by showing how different coun-
tries facing different opportunity costs in the production of different goods
can benefit from free trade with other countries. According to Bicksler and
Chen, differential information in different markets, institutional restrictions,
and transactions costs create "some market imperfections and the presence
4 For example, see Rudnick (1987).
54 Federal Reserve Bank of Richmond Economic Quarterly
of comparative advantages among different borrowers in these markets" (p.
646). These market imperfections, according to Bicksler and Chen, provide the
economic rationale for interest rate swaps.
The Quality-Spread Differential
All firms pay a credit-quality premium over the risk-free rate when they issue
debt securities. These credit-quality premiums grow larger as the maturity of
the debt increases. Thus, whereas a firm, call it firm A, might pay a credit-
risk premium of 50 basis points over the risk-free rate on its short-term debt
obligations, the credit-quality premium it is required to pay on longer-term
debt, say ten-year bonds, might rise to 100 basis points.
Not surprisingly, firms with good credit ratings pay lower risk premiums
than firms with lower credit ratings. Moreover, the credit-quality premium rises
faster with maturity for poorer credits than for good credits. Thus, if firm B
has a poorer credit rating than firm A, it might pay a credit-risk premium of
100 basis points on its short-term debt while finding it necessary to pay 250
basis points over the risk-free rate to issue long-term bonds. The quality spread
between the interest rate paid by the lower-rated firm and that paid by the
higher-rated firm is only 50 basis points in the short-term debt market, but
rises to 150 basis points at longer maturities. The quality-spread differential,
the difference in the quality spread at two different maturities, is 100 basis
points in this example. Firm A has an absolute cost advantage in raising funds
in either the short- or long-term debt markets, but firm B has a comparative
advantage in raising funds in short-term debt markets.
To explore this line of reasoning in more detail, suppose firms A and B
both need to borrow funds for the next two periods, t = 1, 2. Let rf (t) denote
the period t short-term (one-period) risk-free interest rate and rf the long-term
(two-period) fixed risk-free rate. The period t cost of short-term debt to firm A
is the short-term risk-free rate plus the credit-quality spread qA(t). To issue long-
term fixed-rate debt, firm A would be required to pay rf + qA, where qA denotes
the long-term quality spread. Define qB(t) and qB analogously. Assuming firm
A has the better credit rating,
qA(1) qB(1), and
qA qB.
An increasing quality spread means that
qB(1) - qA(1) < qB - qA.
Conditions Necessary for Arbitrage to Be Feasible
Under certain assumptions, both firms could lower their funding costs if firm
A were to issue long-term debt, firm B were to issue short-term debt, and they

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