Interest Rate Swap and Corporate Default

Urban Joseph Jermann () and Vivian Z. Yue ()
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Vivian Z. Yue: Economics New York University

No 866, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: Interest rate swaps are among the most popular derivative contracts. With an interest rate swap, fixed interest payments are exchanged for payments linked to a floating rate. In this paper we develop a dynamic stochastic general equilibrium model to study corporate debt financing and the use of interest rate swaps in the presence of default risk. In our model, there are overlapping generations of firms which face productivity shocks. Representative investors are infinitely lived and risk averse. It takes two periods for a firm to produce output. In order to finance investment, firms can issue long term debt or roll over short term debt. We allow firms to default on their debt. In the case of default, bond investors get a partial debt repayment that is proportional to the firm's output. Therefore, in equilibrium, a firm pays a default premium which is fixed for long-term debt financing and which fluctuates for short-term debt. Using interest rate swaps, firms are able to decouple their choice of debt maturity and interest rate exposure. We analyze firms' optimal financing and investment decisions with endogenous maturity choice and default. We also study how interest rate swaps affect the risk-free rate, corporate default rate, and business cycles. In particular, the existence of default reduces the default probability and has a positive effect on investment and consumption. The model illustrates the quantitative importance of interest rate derivatives for corporate finance and the macroeconomy.

Keywords: Bankruptcy; Interest Rate Swaps; Bond Pricing (search for similar items in EconPapers)
JEL-codes: E22 G12 G33 (search for similar items in EconPapers)
Date: 2006-12-03

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Persistent link: http://EconPapers.repec.org/RePEc:red:sed006:866

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