Interest Rate Swaps and Economic Exposure

Gautam Goswami and Milind Shrikhande
Federal Reserve Bank of Atlanta
Working Paper 97-6
October 1997

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The interest rate swap market has grown rapidly. Since the inception of the swap market in 1981, the outstanding notional principal of interest rate swaps has reached a level of $12.81 trillion in 1995. Recent surveys indicate that interest rate swaps are the most commonly used interest rate derivative by nonfinancial firms and that nonfinancial firms are major users of interest rate swaps. In this paper, we provide an economic rationale for the use of interest rate swaps by such nonfinancial firms. In a global economy, given the floating exchange rate regime, nonfinancial firms face economic exposure in the presence of foreign competition. Asymmetric information about economic exposure leads to mispricing of the firms' debt, and the firm chooses either short-term or long-term debt to minimize the cost of debt. We show that when there is a favorable (unfavorable) exchange rate shock, an exposed firm chooses short-term (long-term) debt together with fixed-for-floating (floating-for-fixed) interest rate swaps. Given interest rate expectations, interest rate swaps enable the firm to minimize the cost of fixed or floating rate debt.

JEL classification: D43, D82, F30

Key words: nonfinancial firms, economic exposure, globalization

The authors gratefully acknowledge helpful discussions with Peter Abken, Sris Chatterjee, Gerald Gay, David Nachman, Tom Noe, Michael Rebello, Stephen Smith, and Larry Wall. They thank the participants of the Atlanta Finance Workshop, the 1994 Financial Management Association Annual Conference, the Southern Finance Association Meetings, and the 1995 Global Finance Conference for helpful comments. They also thank an anonymous referee and Anthony Herbst, discussant at the 1995 Global Finance Conference, for thoughtful comments. The authors acknowledge research support from the College of Business Administration Research Council, Georgia State University, and the Center for International Business Education and Research at the DuPree School of Management, Georgia Institute of Technology, respectively. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Gautam Goswami, Fordham University, GBA, Lincoln Center, 113 West 60th Street, New York, New York 10023, 212/636-6181,; and Milind M. Shrikhande, Georgia Institute of Technology, DuPree School of Management, 755 Ferst Drive, Atlanta, Georgia 30332-0520, 404/894-5109 or Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713, 404/498-8974,