Interest rate swaps in an agency theoretic model with uncertain interest rates

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Abstract

This paper reconciles market participants' claims that interest rate swap financing may reduce financing costs through ‘comparative advantage’ with academic arguments questioning the existence of comparative advantage. The findings suggest that the combination of short-term debt and interest rate swap may reduce financing costs by allowing high-risk firms to reduce agency costs without incurring interest rate risk.

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    As in their analysis, our model focuses on bankruptcy costs as a motive for risk management. Wall (1989) links swap usage to some classic agency problems associated with long-term debt. For instance, Myers (1977) pointed out that long term debt can lead to under-investment, because creditors share the benefit of new investments through a reduced probability of bankruptcy.

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    Haushalter (2000) finds support for the argument that financing costs influence firms’ hedging decisions. Harper and Wingender (2000) find strong evidence for Wall’s (1989) hypothesis of agency cost reduction by interest rate swaps. In contrast to the richness of studies examining the determinants of corporate risk management policy, studies analyzing the valuation impact of risk management are relatively few.

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    For example, a U.S. firm may be able to borrow easily at home but have more limited and less favorable access to foreign capital. Taking another approach, Wall and Pringle (1988, 1989) demonstrate that interest rate swaps allow firms to reduce agency costs, making swaps an attractive alternative to other financing techniques. Traditional theories of intermediation have centered on transaction costs and asymmetric information.

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    The existence of asymmetric information may be the cause of agency costs. The theory of asymmetric information is similar to Wall's (1989) agency cost reduction theory. Wall develops a framework for predicting the mutual benefit to firms using interest rate swaps and shows analytically that high-risk firms preferring fixed rates can reduce agency costs by using interest rate swaps.

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The opinions expressed in this paper are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

The author thanks Thomas Cunningham, Mark Flannery, Frank King, Paul Koch,David Peterson, Jeffrey Rosensweig, participants at the Federal Reserve System Committee on Financial Analysis, and two referees for helpful comments on earlier drafts.

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