Swaps: Plain and Fanciful

The outstanding face amount of plain vanilla interest rate swaps exceeds two trillion dollars. While pricing and hedging of such swaps appear to be quite simple, many existing theories are based on the incorrect characterization of a swap as a simple exchange of a fixed for a floating rate note. This characterization is not consistent with standarized swap contracts and the treatment of swaps in bankruptcy. This paper provides an alternative perspective on swaps.     

The pricing of interest rate swaps

Interest rate swaps have become an important tool for financial institutions because they provide a convenient way to reduce interest rate risk. Swaps allow financial institutions to obtain short-term deposits in the local deposit market and then transform these into longer-term liabilities. The growth of swaps has been explosive, with the swap market growing from nothing in 1981 to an estimated $889 billion in 1987. In addition to their role in managing interest rate risk, swaps have become important to financial managers for other reasons, and as a result the swap market is monitored by financial managers as are money and capital markets. Because of its growing importance, an empirical perspective on how swaps are priced is needed. This article develops a simple market model and then estimates the model using data provided by three major swap market participants.     

Too much of a good thing? A theory of short-term debt as a sorting device

This paper shows that the liquidity risk associated with short-term debt financing can be used to sort insolvent firms out of financial markets when their solvency risk is private information. Notwithstanding this sorting role of short-term debt, unregulated financial firms tend to choose an inefficiently short debt maturity structure. This inefficiency arises for two reasons. First, by issuing more short-term debt, low-risk firms reduce their expected funding costs. This leads to a misalignment of private and social incentives as firms fail to fully internalize the social costs of becoming illiquid. Second, while the sorting role of short-term debt is reflected in a decline of long-term interest rates when more short-term debt is issued, creditors’ inability to observe firms’ solvency risk leads to an excessive reduction of long-term interest rates. This further distorts firms’ funding choice towards short-term debt.     

The Determinants of the Maturity of Corporate Debt Issues

We document the determinants of the term to maturity of 7,369 bonds and notes issued between 1982 and 1993. Our main finding is that large firms with investment grade credit ratings typically borrow at the short end and at the long end and of the maturity spectrum, while firms with speculative grade credit ratings typically borrow in the middle of the maturity spectrum. This pattern is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation, but are screened out of the long-term debt market because of the prospect of risky asset substitution.     

The expectations hypothesis of the term structure when interest rates are close to zero

In an economy where cash can be stored costlessly in nominal terms, the nominal interest rate is bounded below by zero. This paper derives the implications of this non-negativity constraint for the term structure and shows that it induces a nonlinear and convex relation between short- and long-term interest rates. The long-term rate responds asymmetrically to changes in the short-term rate, and by less than that is predicted by the benchmark linear model. In particular, a decrease in the short-term rate produces a smaller response in the long-term rate than an increase of the same magnitude. The empirical predictions of the model are examined using data from Japan.     

中国利率市场的价格发现——对国债现货、期货以及利率互换市场的研究

本文采用信息份额模型和基于向量自回归(VAR)模型的格兰杰因果检验,研究了国债现货、国债期货和利率互换三个市场之间的价格发现机制。信息份额模型表明,从整体来看利率互换相对于国债期货和国债现货都具有信息优势,而国债期货相对于国债现货具有信息优势。另外,国债期货的价格发现能力相对于另外两个市场都在随时间增强。格兰杰因果检验结果显示,利率互换在价格发现中单向引领国债期货以及国债现货,国债期货单向引领国债现货。所有结果一致表明, 利率互换和国债期货这两种利率衍生产品在引导中国利率市场价格发现中发挥了重要作用。     

Small Firm Capital Structure and the Syndicated Loan Market

We show that small firms using syndicated loans for their mid- and long-term financial needs have significantly higher leverage than firms that do not borrow in this market. This difference cannot be attributed to firm characteristics like the availability of growth opportunities, asset tangibility, R&D spending, profitability and net sales that are known to influence capital structure. We also find that the capital structure of other firms that borrow in the syndicated loan market is not different from those that do not. We show that already highly leveraged small firms are more likely to borrow in the syndicated loan market than other firms. The higher debt in the capital structure of small firms that rely on syndicated loans consequently can be attributed to the availability of capital rather than demand for capital, as shown more generally by Faulkender and Petersen (Rev Financ Stud 19(1):45?C79, 2006).     

Hedging or Market Timing? Selecting the Interest Rate Exposure of Corporate Debt

This paper examines whether firms are hedging or timing the market when selecting the interest rate exposure of their new debt issuances. I use a more accurate measure of the interest rate exposure chosen by firms by combining the initial exposure of newly issued debt securities with their use of interest rate swaps. The results indicate that the final interest rate exposure is largely driven by the slope of the yield curve at the time the debt is issued. These results suggest that interest rate risk management practices are primarily driven by speculation or myopia, not hedging considerations.     

The Effects of Bank Lending in an Open Economy

This article assesses the effects of bank lending in a small open economy with a floating exchange rate and sticky prices. A theoretical model with costly financial intermediation is developed for New Zealand. The results show that the long-run and business cycle effects of bank lending are small. Whether firms borrow from financial intermediaries or public debt markets is unlikely to affect economic activity. In other words, the financial structure, or degree to which a country's financial system is intermediary based or market based, does not matter.     

Institutional investment horizons,corporate governance,and credit ratings: International evidence

Using a comprehensive set of firms from 57 countries over the 2000–2016 period, we examine the relation between institutional investor horizons and firm-level credit ratings. Controlling for firm- and country-specific factors, as well as for firm fixed effects, we find that larger long-term (short-term) institutional ownership is associated with higher (lower) credit ratings. This finding is robust to sample composition, alternative estimation methods, and endogeneity concerns. Long-term institutional ownership affects ratings more during times of higher expropriation risk, for firms with weaker internal corporate governance, and for those in countries with lower-quality institutional environments. Additional analysis shows that long-term investors facilitate access to debt markets for firms facing severe agency problems. These findings suggest that, unlike their short-term counterparts, long-term investors improve a firm's credit risk profile through effective monitoring.     

An empirical analysis of bank interest rate swaps

Considering the characteristics of banks that do and do not report interest rate swaps, the long-term interest rate exposure of a bank and the likelihood and extent of swap market participation are found to be positively related. Key to the finding is the inclusion of variables related to the provision of swap market intermediary services, which significantly explain both the likelihood of swap market participation and the notional value of outstanding swaps. The results suggest that the likelihood and extent of swap market participation by low-capitalized banks is less than for other banks.     

Why Do Firms Raise Foreign Currency Denominated Debt? Evidence from Finland

This study examines the determinants of the decision to raise currency debt. The results suggest that hedging figures importantly in the currency–of–denomination decision: firms in which exports constitute a significant fraction of net sales are more likely to raise currency debt. However, firms also tend to borrow in periods when the nominal interest rate for the loan currency, relative to other currencies, is lower than usual. This is consistent with the currency debt issue decision being affected by speculative motives. Large firms, with a wider access to the international capital markets, are more likely to borrow in foreign currencies than small firms.     

事实汇率制度选择、企业生产率与对外直接投资

企业“走出去”和汇率制度安排灵活化是中国参与全球经济的两大典型特征,本文从企业异质性视角讨论了双边事实汇率制度选择对企业对外直接投资的影响效应。理论层面上,本文将Gali and Monacelli(2005)的一般均衡框架拓展为两国模型,发现双边固定汇率制度降低了企业进入东道国开展OFDI活动的生产率阈值,提高了企业对外直接投资倾向。同时,尽管企业生产率的提升能够促进企业对外直接投资活动,但其促进力度明显不及双边事实固定汇率制度安排。实证层面上,本文采用了中国商务部公布的2000-2013年《境外投资企业(机构)名录》等微观企业数据,发现双边事实固定汇率制度能使企业进行OFDI概率平均提高0.8%~55.4%。考虑其他异质性因素及内生性问题后,本文主要结论依然稳健。     

The Structural Relation Between Mortgage and Market Interest Rates

This paper analyzes the dynamic relationship between primary and secondary mortgage markets and the short-term and long-term market interest rates. Using a series of monthly data on fixed rate mortgage rates and GNMA rates, we explore the dependence and speed of adjustment in these primary and secondary mortgage rates to each other as well as to the long and short-term government rates. The results indicate that residential mortgage rates in general, appear to follow the long-term rate and are not very sensitive to movements in the short-term interest rate.     

Credit derivatives with multiple debt issues

We evaluate the most actively traded types of credit derivatives within a unified pricing framework that allows for multiple debt issues. Since firms default on all of their obligations, total debt is instrumental in the likelihood of default and therefore in credit derivatives valuation. We use a single factor interest rate model where the exponential default frontier is based on total debt and is made coherent with observed bond prices. Analytical formulae are derived for credit default swaps, total return swaps (both fixed-for-fixed and fixed-for-floating), and credit risk options (CROs). Price behaviors and hedging properties of all these credit derivatives are investigated. Simulations document that credit derivatives prices may be significantly affected by terms of debt other than those of the reference obligation. The analysis of CROs indicates their superior ability to fine-tune the hedging of magnitude and arrival risks of default.     

Do banks price their informational monopoly?

Theory suggests that banks’ private information lets them hold up borrowers for higher interest rates. Since new information about a firm is revealed at the time of its bond IPO, it follows that banks will be forced to adjust their loan interest rates downwards after firms undertake their bond IPO. We test this hypothesis and find that firms are able to borrow at lower interest rates after their bond IPO. Importantly, firms that get their first credit rating at the time of their bond IPO benefit from larger interest rate savings than those that already had a credit rating. These findings provide support for the hypothesis that banks price their informational monopoly. We also find that it is costly for firms to enter the public bond market.     

Pre‐Issuance Hedging of Fixed‐Rate Debt

This article analyzes several corporate hedging strategies to manage interest rate risk on fixed‐rate debt prior to issuance. The authors start by considering these strategies using a highly stylized model: a binomial forward interest rate tree that, while simple in design, illustrates derivative pricing methodologies that are used in practice. Under a given rate volatility assumption, they demonstrate expected outcomes when entering a forward bond contract, a forward‐starting pay‐fixed interest swap, and a purchased option on that swap, as well as the “default” alternative of doing nothing. In principle, the decision of whether or not to hedge, as well as how to do so, depends on management's view of future interest rate volatility and degree of comfort with possible outcomes. The authors then assess the pros and cons of hedging strategies, with considerable emphasis on practical considerations. For example, while their theoretical model would allow an issuer to “lock” a specific debt issuance, in practice one can hedge only “benchmark” interest rate risk. The authors describe the use of both Treasury locks and forward‐starting swaps to address unexpected benchmark yield changes, and discuss how factors such as the time to issuance affect an issuer's choice of instrument. For instance, Treasury locks are typically used when the time to issuance is relatively short, while interest rate swaps are more common for longer times to issuance. The article also discusses circumstances in which a “do nothing” strategy may be preferable to other alternatives, as well as the disadvantages of issuing in advance. Finally, the authors describe the impact of financial accounting on different hedge strategies.     

Interest Rate Risk Management in Major Finnish Firms

The interest rate policies of Finnish firms appear risk aversive, but hedging decisions are influenced by market view. Managers find they can forecast trends in interest rate development, and employ the forecasts in the choice of debt and hedging instruments. The use of risk assessment methods and hedging instruments are related to firm size but not to leverage. Most frequently employed hedging instruments are interest rate swaps and forward rate agreements. The respondents find their firms' interest rate risk management is successful, but performance is seldom measured against an explicitly defined benchmark.     

Dynamic Relationship between Housing Values and Interest Rates in the Korean Housing Market

The goal of this study is to identify the long-term relationship between housing values and interest rates in the Korean housing market, using the cointegration test and spectral analysis. The result shows a long-term negative (–) equilibrium relationship between housing values and interest rates. Moreover, the Granger causality test for confirming the short-term dynamic relationship between these variables shows one-way causality from interest rate to the growth rate of housing values, while the transfer function model demonstrates concretely the causal structure of this relationship. These findings suggest that the interest rate adjustment policy in the Korean housing market can work very effectively and will contribute to forecasting the growth rate of future housing values. This study was supported from the 2003 Daegu University Research Fund     

Interventions in Markets with Adverse Selection: Implications for Discount Window Stigma

I study the implications for central bank discount window stigma of a workhorse model of adverse selection in financial markets. In the model, firms (banks) need to borrow to finance a productive project. There is limited liability and firms have private information about their ability to repay their debts, which gives rise to the possibility of adverse selection. The central bank can ameliorate the impact of adverse selection by lending to firms. Discount window borrowing is observable and it may be taken as a signal of firms' credit worthiness. Under some conditions, firms borrowing from the discount window may pay higher interest rates to borrow in the market, a phenomenon often associated with the presence of stigma. I discuss these and other outcomes in detail and what they suggest about the relevance of stigma as an empirical phenomenon.