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| Author: | Yu, W.T. Pang, W.K. Li, L.K. |
| Title: | Borrowing cost reduction by interest rate swaps - an option pricing analysis |
| Journal: | European Journal of Operational Research
2004 : MAY, VOL. 154:3, p. 764-778 |
| Index terms: | Corporate finance Capital structure of companies Capital costs Options Interest rates |
| Language: | eng |
| Abstract: | Interest rate swaps generally involve two firms with different credit ratings. A quality spread differential (QSD) is observed to exist at different credit ratings to decrease their borrowing costs through interest rate swaps by utilising their comparative advantage in borrowing in different markets. The credit ratings of firms are determined by credit risk factors such as leverage and volatility of earnings asset value. This paper investigates the effect of the leverage and the volatility on the behaviour of risk premia between firm debts with different credit ratings by using the contingent claim analysis. The results show that the quality spread differential can be explained by the differences in leverage and volatility. In conclusion, this paper shows that interest rate swaps can help the firms to lower borrowing costs without necessarily relying on the arbitrage argument asserted by existing literature. |
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