Journal of Ranking and Finance 13 (1989) 261-270.

North-Holland

INTEREST RATE SWAPS m AN AGENCY THEQRETIC MODEL

m PNTEREST RATES

Larry D. WALL*
Federal Reserve Bank of Atlanta, Atlanta, GA 3030~ USA

ReceivedJune 1987, final version receivedMay 1988

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 tindings suggest that the combination of short-term
debt and interest rate swap may reduce fmancmg costs by allowing high-risk firms to reduce
agency costs without incurringinterest rate risk.

1. Introduction

An interest rate swap is an arrangement under which two organizations

agree to exchange rate payments for a fixed period of time. Interest rate
swaps are, in effect, a series of customized forward contracts. However, unlike
the forward and futures markets, an active swap market exists for maturities
in excess of three years. The interest rate swap market grew from virtual
nonexistence in 1981 to approximately $350 biiion in 1985.’
One of the first types of interest rate swaps is now called the ‘plain vanilla’
swap because of its simplicity. In a typical plain vanilla swap transaction a
lower rated (higher risk) corporation will issue short-term debt (such as
commercial paper) and a higher rated (lower risk) corporation will issue a
long-term bond. The lower rated corporation will then agree to pay the
higher rated corporation a fixed interest rate each period, while the higher
rated corporation will agree to pay a rate base2 on some floating market
interest rate @cl! as LIEC!Y),*
Some market participants such as Banker’s Trust claim that plain vanilla-
*The opinions expressed in this paper are those of rhe author and do not necessarilyrepresent
the views of the Federal Reserve Rank 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 ou Financial Analysis, and
two refereesfor helpful comments on earlierdrafts.
‘The sixe of the swap market is usually stated in terms of the underlying dollars of principal
involved in the transaction.See Shirt&f(1985) for a discussion of the growth of the swap market
and Hammond (1987) for an estimate of its size.
*Hammond (1987) refersto this as ‘the classic swap’.

0378-4266/89/$3.50 0 1989, ElsevierScience Publishers B.V. (North-Holland)

262 L.15.H’cril,Interestrate swaps

type interest rate swaps allow both parties to reduce their funding costs?
These claims have been repeated by Bicksler and Chen (1984), Whittaker
(1987), and Hammond (1987). Hammond (1987, p. 68) suggests that the costs
savings arise because one participant ‘has a competitive advantage in the
bond market’ and the other has ‘a competitive advantage in the floating-rate
market’.
The ability of swaps to reduce funding costs through %omparative
advantage’ has been criticized by Loeys (1985); Smith, Smithson and
Wakeman (1986); and Tumbull(l987). Tumbull draws two conclusions froIln
his model: the type of analysis typically used to support the interest rate
savings of swaps is misleading and both participants to a swap may not gain
if the bond market is efficient. Smith et al. suggest that even if arbitrage was
possible, it could not explain the growth of the swap market. The volume of
swaps should be declining as arbitrage becomes more effective.
This study demonstrates that interest rate swaps may reduce financing
costs without resorting to the comparative advantage story. The rebuttals of
comparative advantage implicitly assume that the inveshzent policy of the
lower-rated firm is independent of its debt maturity. However, Myers (1977);
Bodie and Taggart (1978); and Bamea, Haugen and Senbet (1980) suggest
that a firm may have less of an incentive to under-invest and invest in high
risk projects if it issues short-term debt. The results presented below suggest
that the combination of short-term debt and interest rate swaps allows high
risk firms to reduce their agency costs without incurring interest rate risk.
Two alternative solutions to the agency costs of debt aK considered: short-
term debt without swaps and callable bonds. The results suggest that the
combination may be preferable to short-term debt without swaps when the
combination allows firms to avoid mismatching the duration of their assets
and liabilities. The analysis also suggests that callable bonds reduce but do
not eliminate the under-investment problem and may fail in some cases to
eliminate the incentive to invest in high-risk projects.
The paper is organized as follows: Section 2 analyzes the effect of financing
strategy on firm investment policy. Section 3 considers the effect of financing
strategy on Grrn financing costs assuming a fixed investment policy. Section 4
summarizes the implications of sectiaas 2 and 3 for firm financing policy.
Section 5 considers potential empirical tests. Section 6 presents concluding .
remarks.

3Banker’s Trust advertising supplement to the September 1983 Euromoncy entitled The
InternationalSwapMarket asserts on page 3 that the cost savings is possible because ‘investors
in fixed rate instruments are more sensitive to credit quality than floating rate bank lenders’.
Banker’sTrust placed an advertisementin the October 6, 1987, Wall Street Journal (p. 9 of the
Eastern Edition) claiming to have obtained floating-rate funds for one customer at 200 basis
points below LIBOR through the use of swaps.
 LD. Wall, Interest rate swaps 263

2. Financing strategies and inwstment policy

Myers suggests that non-callable bonds create an incentive to under-invest
because creditors obtain part of the benefit of new investments through a
reduced probability of bankruptcy. Bamea, Haugen and Se&et suggest that
non-callable bonds also create an incentive for risk shifting - substituting
high-risk projects for low-risk ones. Both studies suggest that the agency
costs of non-callable bonds may be reduced by short-term debt and callable
bonds.
Subsection 2.1 will consider the relative abilities of short-term debt and
callable bonds to solve the under-investment and risk shifting problems.
Subsection 2.2 will analyze the ability of the combination of short-term debt
and interest rate swaps to reduce these agency costs.

2.1. Short-term debt and callable bon&

Short-term debt and callable bonds reduce the incentives to under&vest
and shift risk by allowing for recontracting after the firm is revealed to be
following an investment strategy. Non-callable bonds may be repurchased
only at a premium that fully reflects a firm’s reduced risk level and, tbuz,
provide no incentive to follow a low risk investment strategy.
Short-term debt and callable bonds are perfect substitutes in Myers’ as
well as Bodie and Taggart’s models.4 However, their models ignore a
difference between the two financing strategies: short-term debt must be
refinanced but callable bonds are refinanced only if doing so reduces the
firm’s interest expense. Firms that follow a low risk investment strategy will
always obtain a reduced risk premium on their short-term debt but may not
reduce their premium on callable bonds in some states.5
Barnea, Haugen and Se&et (1980, p. 4231) recognize that callable debt
does not always eliminate the under-investment incentive because ‘Under
certain states of nature’ it will be ‘unprofitable to call the debt’. However,
they assert that (p. 1229) ‘the issuance of callable debt with an appropriate
call price resolves the agency problem associated with risk shifting’. They are
correct that callable debt will solve the risk shifting problem at some call
‘These studies recognixed that the two may be significantly diierent in ways that were not
modeled. Myers (1977, p. 159) provides some practical reasons for preferringcallable bonds
when he states ‘This (policy of rolling over short-term debt) seems to be a good solution. but
there are costs of maintaining such a continuous, intimate and flexible relationship’.Bodie and
Taggart(1978, p. 1199) offer an altematirz explanation:‘Nevertheless,whether it (a reluctanceto
rely on short-termdebt) stems from a desire to avoid transaction costs, a fear of credit rationing
or an attempt to exploit borrowers preferredlending habitats, it is a fact that firms issue long
term debt.. .‘.
%ese three studies are carefu: .o point out that short-term debt solves the problems only if
it matures after the investment decision is revealedto the market but before the project matures.
A similar condition is also noted for earlkt possible call date on bonds. The analysis in this
paper assumes that the maturity on the short-term debt and the call provisior for the bonds
satisfy these constraints.
264 LD. Wdl,interestruteswaps

price. The issue is whether this call price is below the initial market value of
the bonds. They present a graphical example and argue that the caG price of
the bond ‘may well lie in the neighborhood of the market value of callable
debt’? Thus, they suggest that the debt in their example is ‘not neces&ly
inconsistent’with observed market practice.
Bamea, Hougen, and Se&et’s example of callable bonds solving the risk
shifting problem is not conclusive since there is nothing in their example to
guarantee the proulem will be solved at a price above the initial market
price. Whether observed callable bonds will solve the risk shifting problem is
an empirical question that can only be answered for specific cash flow and
interest rate assumptions?

2.2. The ctwnbikationofshort-term tkebtand interest rate swaps

The combination of short-term debt and interest rate swaps reduces
agency costs in the same manner as short-term debt without interest rate
swaps. Swaps allow the firm to issue short-term debt without the exposure to
changes in interest rates.
The effect of interest rate swaps on a firm’sfinanc%gcosts may be seen by
comparing its costs of issuing short-term debt, both with and without an
interest rate swap. Assume that the firm issuing short-term debt is a low
quality firm and that it is going to enter into a swap with a high quality
fum. This assumption follows the examples in the introduction and its
implications are discussed below. The rate on short-term debt may be
decomposed into a risk-freecomponent and a firm-specificrisk premium:

ST=(rl +tt(x))F, where (0

ST=cost of short-termdebt,
rl =default risk-freeinterest rate on one period debt,
n(x)=risk premium on one period debt issued by the firm given that firm
has followed investment strategy x, and
F=principal of the debt.

6Bamea, Haugen and Senbet (1980, p. 1229).

‘If bonds that are only caifabte at or above par may fail to solve the risk incentive problem in
some cases then why do Rrms not issue bonds with call prices below paf? One explanation is
that reducing the call piice effectively reduces the value of a callable bond as a fixed rate
hnancing tool and makes the bond more like short-term debt. Consider the extreme case of a
bond that is issued with a face value of !§I,00 and is callable at SO.00after one period. Investors
in such a bond would demand an ‘interestrate’in excess of 100 percent to compensate them for
both the principal and required return. Such a bond would be eqivalent to short-term debt
because the firm would almost certainly call the bond at the end of the first period given the
high rate of *interest’promised by the bond.
Firms have an incentive to follow a low-risk investment strategy wit&
short-termdebt to minim& the risk premium on their &bt.
In crder to hedge its entire short4erm debt issue for ILperiods, the low
quality firm would enter into an n period swap where the notational
principal of the swap equals the principal amount of its ou&@ndingdebt.*
Assume that the swap’s pricing is based on the MawIt risk-free yield curve.
Then the low quality firm is going to pay a rate based on the de&t& risk-
free rate for n period debt, r, and some premium to its counterpar@,sp. The
swap premium compensates the higher quality firm for the risk that the low
quality Iirm may default on the swap and may &o provide au incentive for
high quality firms to enter into swaps? The premium is a coatant
percentage that is determined at the beginning of the swap. In return, the
higher quality lirm pays the default risk-free rate on one period debt to the
low quality firm. The net payments under the swap by the low quality firm
are:

SW=@)-(r,+sp)F, where (2)

SW= net payments under the swap agreement,

r”==defaultrisk-lice rate on n period &bt, and
sg= premium paid on swap by the floating-ratep;ryer.

The net costs of using the combinauon of short-term debt and interest rate
swaps may be obtained by substractingeq. (2) from eq. (l),

NP=ST-SW (3)

=(&+tr(x)+sp)F,
where NP =net cost of financing with short-term debt and interest rate
swaps.

The combination of swaps and short-term debt maintains the advantage of

short-termdebt. Note that the swap solution to the agency problem requires
that the floating rate depend solely on a market rate of interest. If the
floating rate depends on the lower quality lirm’s actual interest expense then
*The principal amount used in an interest rate swap calculation ~3 call4 *he notional
principalbecause the two parties never exchange the principal amount.
‘Both fi=msface some risk that the other participantin the swap tmruction will default. The
higher quality firm is likely to receive a net payment for default risk, however, because of the
greaterprobability that the low quality firm will default.
266 L9. Wall, Interest rate swaps

the incentive to follow a low risk investment strategy would be lost. The
assumption of a market-determined floating rate is consistent with observed
practice. Hammond (1987, p. 67) reports that a ‘vast majority’ of interest rate
swaps are based on LIBOR, with rates such as the U.S. commercial paper,
Treasury bill, prime rate, and Federal Funds rates used ‘occasionally’.1o
One possible problem with the use of interest rate swaps is that there is
some non-zero probability -that the other party will default. However, a
default would not affect the ability of the combination of short-term debt
and swaps to solve the agency cost problems. The short-term debt issue
provides the correct incentives even if the higher quality firm defaults on the
swap.
Another objection to the use of this financing strategy is that it may
increase agency costs at the higher quality firm. If the magnitude of the
incentives to the two firms were equal then the net gain of entering a swap to
change the maturity structure of their debt would be zero. However, the
costs of changing investment strategy may be greater for a higher rated Erm
because it has already ‘paid its dues’ to obtain a good reputation in the
financial markets, and changing investment strategy would sacrifice the firm’s
ability to issue highly rated debt in the future. The gains to changing
investment strategy by higher rated firms are smaller because more of the
costs of a change in investment strategy is borne by the equity-holders.11

3. Interest rate risk

Firms that wish :o reduce the under-investment and risk incentive
problems may always do so by issui.38 short-term debt, or by combining
short-term debt with interest rate swap;. In at least some cases a firm may
also reduce these agency costs with callable debt. However, the three
financing strategies have very different implications for the firm’s exposure to
changes in market interest rates. The firm is fully exposed to rate changes
with short-term debt. Callable bonds set a ceiling on the firm’s exposure to
rate changes and allow it to exploit a drop in market rates. However, firms
must pay for the option to call the bonds through the payment of a higher
interest rate. The combination of short-term debt and swaps eliminates the
t”Arak, Estrella, Goodman, and Silver (1987) also rely on the ability of the combination of
interest rate swaps and short-term debt to immunixe a firm from changes in the risk-free rate
while maintaining exposure to changes in fii credit premiums. Their model considers the
financing decision of a firm that anticipates a reduction in its credit risk premium. Their model
considers four types of financing fixed-rate notes, floating-rate notes, short-term debt and the
combination of short-termdebt and interest rate swaps. The two note options do not allow the
firm to benefit from a drop in its credit risk premium while the short-term debt option exposes
it to interest rate risk. The combination of short-termdebt and swaps allows the firm to obtain
the benefits of the lower risk premium without any interest rate risk.
“Stulz and Johnson (1985) state that ‘If the existing debt of the firm is not very risky, there
cannot be much of an under-investmentproblem.. .‘.
 LD. Wcrll,Interest rate swaps 261

firm’s exposure to &ages in market interest rates.12This section examines

the implications of interest rate risk for the optimal financingstrategy.

3.1. Potential costs of interest rate rbk

The fim’s decision to hedge changes iu interest rate risk is examined by
Smith and Stulx (1985). One reason for hedging may be to reduce the costs
of financial distress. Smith and Stulx acknowledge that the magnitude of
Einancialdistress costs is unclear. However, even small bankruptcycosts may
justify hedging if the costs of hedging are also small. A second reason for
hedging is to reduce contracting costs. Smith and Stulx note I’rha a
corporation’smanagers,employees, suppliers, and customers may be unable
to hedge their specific claims on the corporation. Hedging will be efficientin
this case if the reduced payments to mauagers,employees, and suppliers plus
the added revenue from customers exceeds the costs of hedging. A third
possible justification for hedging is taxes. Smith and Stulz show that hedging
may be optimal if effective marginal tax rates are an increasing funcGonof
the pre-tax value of the firm.

3.2. Mnimizing the risk of interest rate changes

The effect of interest rate changes on a firm’s net income depends on the
changes’ effects on both operating revenues and financing costs. Thus, the
optimal strategy for hedging interest rate risk depends on the effect of
interest rate changes on a firm’s operating revenues. If operating revenues
have a high, positive correlation with interest rates then floating-rate debt
may minimize the effect of rate changes on net income. Alternatively, if
operating revenues have a low or negative correlation with rates then fixed-
rate fundingmay reduce costs.

4 Optimal fhrancingstrategy
The analysis in this paper focuses on two aspects of the debt maturity and
callability choice: its impact on firm investment policy and on the costs of
financialdistress through its effect on interest rate risk. The results have clear
implications for high- and low-risk firms if agency costs and interest rate risk
are the only factors influencinga firm’sdebt maturity policyP
‘*Assuming tie other party to the swap does not default.
13The analysis may not hold for many hostile takeovers and leveraged buyouts that are
financed with junk bonds. The gains from rationalizing the operations of these firms and
redprtingtheir operating costs mey temporarily exceed the gains from new investment. When
these firms reach optimum operating efficiency then the problems of under-investmentand risk
shifting may reemerge.
 268 LA Wall. Interest rate swaps

4. I. Financing high-risk firms

High-risk firms may face sigr$lcant incentives to under-invest and invest
in high risk projects. Shor%:.,?rmdebt without interest rate swaps may be
appropriate for high&% GIY.:. whose cash flows are highly positively
correlated with market inteijs,.z;l
a%es.
If short-term debt exwLs if:.*> firm to substantial interest rate risk then it
should either combine short-tc-n! debt with swaps or issue callable bonds. In
order for an n period callable Sand to dominate the short-term debt plus
swaps strategy, the following cG.dition must hold:

E(CFDl callable bonds) + E(A) < E(CFDlswaps) + fi [sp(F)B,], (6)

=
where

E(CFDlcallable bonds) =expectcd net present value of the costs of financial

distress if the firm issues callable bonds,
I%9 =expected net present value 0; the agency costs
associated with callable bonds,
E(CFDlswalz) =expected net present value of the costs of financial
distress if the firm issues the combination of short-
term debt and interest rate swaps, and
Bt =discount factor applied to cash flows paid in period
t.

The condition requires that the expected financial distress costs and agency
c6sts associated w!th callable bonds be less than the costs of financial distress
associated with the swap financing strategy plus the net present value of the
swap premium.

4.2. Low-risk firms

Low-risk firms have substantially less incentive to under-invest and invest
in high risk projects than do high-risk firms. Thus, interest rate risk is more
important to the choice of a financing strategy. If floating-rate funds reduce
interest rate risk then the firm has a choice: (1) it may issue short-term debt
or (2) it may issue long-term debt and use an interest rate swap to convert
the interest payments to a floating-rate stream. The combination of long-
term debt and swaps may reduce financing costs if high-risk firms share part
of their agency cost gains with low-risk firms. If the low-risk firm uses a
. swap to obtain floating rate funding then it must decide whether to issue a
 LJ). Wull, Interest rareswaps

callable or non-callable bond to obtain fixed-rate funds. Callable bonds may

be preferred if they provide any agency cost savings.
Low-risk firms that desire fixed-rate funding also have several options: (1)
non-callable bonds, (2) callable bonds, and (3) short-term debt plus an
interest rate swap. Alternatives 2 and 3 are ~tiperior to 1 if they provide an
agency cost savings. Alternative 2 may be preferred to alternative 3 if the
market requires fixed-rate payers to pay some premium to induce floating-
rate payers to participate in the swap market. The savings in agency costs for
low-risk firms may be less than the swap premium.

5. Potential empiricaltests
One potentially testable implication of the above theory is that the interest
rates on long-term bonds issued by lower quality firms contain a larger
premium for agency costs than bonds issued by high quality firms. Examin-
ation of puttable bonds may provide some evidence on the presence of an
agency cost premium since both short-term debt and a put feature allow
creditors to demand recontracting if the &m follows a high risk investment
strategy. Chatield and Moyer (1986) suggest that adding a put feature to a
bond may reduce required bond yields by as much as 89 basis points. One
difficulty with analysis of bond rates is the need to distinguish between
premiums charged for risk elements under management’s control (i.e.,
potential agency costs) versus those elements outside managerial control.
A second set of testable implications relate to the theory’s ability to
explain firm financing decisions, especially a firm’s decision to use interest
rate swaps. One consideration that would need to be addressed in such a test
is the presence of other, not mutually exclusive explanations for the use of
swaps such as those offered by Arak et al., Loeys, and Smith et al. A second
complication is limited data availability on the use of swaps. Data on
individual swap transactions are not publicly available. Corporations may
publicly disclose their use of swaps, but there is currently no spedk swap
disclosure requirement.14

6. Concl~ion
Some proponents of interest rate swaps have suggested that swaps reduce
financing costs by exploiting firms’ colmpaaative advantages. However, the
comparative advantages explanation has been criticized as misleading and
unable to account for the growth of the interest rate swaps
14The National Automated Accounting Research System (NAARS) provides an autoniated
way of scanning corporate reports to find referenczsto interest rate swaps (sometimes called
interest rate exchange agreements).This file is maintained k the AmericanInstitute of Certif~d
Public Accountants and is available through the LEXiS.
270 LD. Wall,lntewstrate swaps

paper reconciles the two views by showing that a reduction in interest

expense is possible without relying on inefficient securities markets. The
results suggest that the combination of short-term debt and interest rate
swaps allows firms to reduce agency costs without incurringinterest rate risk.
One policy implication is that changes in swap regulation should consider
both costs and benefits. Interest rate swaps may be a recent innovation;
however, they perform a valuable economic function. Regulations that
impose costs on the swap market may reduce swaps use more than is
optimal.
The analysis also has implications for empirical research on corporate
maturity structures. Studies examining a firm’ssensitivity to interest rate risk
through reported debt maturities may produce misleading results if the
researcherdoes not have data on interest rate swaps. However, research on
the agency costs of differentfunding strategies need not be concerned about
interest rate swaps.

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explanation, Presented to the Financial ManagementAssociation Meetings in Las Vegas.
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