TAILIEUCHUNG - Interest Rate Swaps and Economic Exposure

In the 1980s and 1990s, policymakers took a big leap, arguing that the new microfinance institutions should be profitable -- or in the prevailing code language, they should be “financially sustainable.” The argument for emphasizing profit-making microfinance institutions proceeds in three steps. First, it holds that small loans are costly for banks to administer but that poor households can pay high interest rates. Moneylenders, it is often pointed out, routinely charge (annualized) interest rates of over 100 percent per year, so, it is reasoned, charging anything lower must be a benefit; CGAP (1996) articulates this argument sharply. Within. | Interest Rate Swaps and Economic Exposure Gautam Goswami and Milind Shrikhande Federal Reserve Bank of Atlanta Working Paper 97-6 October 1997 Abstract 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 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 shortterm 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 .

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