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Interest Rate Swap and Corporate Default

Author

Listed:
  • Urban Jermann
  • Vivian Z. Yue

    (Economics New York University)

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.

Suggested Citation

  • Urban Jermann & Vivian Z. Yue, 2006. "Interest Rate Swap and Corporate Default," 2006 Meeting Papers 866, Society for Economic Dynamics.
    • Handle: RePEc:red:sed006:866
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    References listed on IDEAS

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    Cited by:

    1. Urban J Jermann, 2020. "Negative Swap Spreads and Limited Arbitrage," The Review of Financial Studies, Society for Financial Studies, vol. 33(1), pages 212-238.
    2. Mariya Gubareva & Maria Rosa Borges, 2018. "Rethinking economic capital management through the integrated derivative-based treatment of interest rate and credit risk," Annals of Operations Research, Springer, vol. 266(1), pages 71-100, July.
    3. Ma, Chang & Valencia, Fabián, 2024. "Welfare gains from market insurance: The case of Mexican oil price risk," Journal of International Money and Finance, Elsevier, vol. 142(C).
    4. Raymond Kim, 2021. "Disproportionate costs of uncertainty: Small bank hedging and Dodd‐Frank," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(5), pages 686-709, May.
    5. Kristina Garskaite-Milvydiene & Raimonda Martinkute-Kauliene, 2021. "Examination of the Relationship between Derivative Financial Instruments and the Economic Development of Lithuania," Contemporary Economics, University of Economics and Human Sciences in Warsaw., vol. 15(2), April.
    6. Sven Klingler & Suresh Sundaresan, 2018. "An explanation of negative swap spreads: demand for duration from underfunded pension plans," BIS Working Papers 705, Bank for International Settlements.
    7. Mariya Gubareva, 2018. "Historical Interest Rate Sensitivity of Emerging Market Sovereign Debt: Evidence of Regime Dependent Behavior," Annals of Economics and Finance, Society for AEF, vol. 19(2), pages 405-442, November.
    8. Bai, Hang, 2021. "Unemployment and credit risk," Journal of Financial Economics, Elsevier, vol. 142(1), pages 127-145.

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    More about this item

    Keywords

    Bankruptcy; Interest Rate Swaps; Bond Pricing;
    All these keywords.

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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