Reference rate

Abstract: This paper describes the firm's decision to borrow short-term versus long-term and shows how the introduction of interest rate swaps affects this choice. The model shows that in the absence of a swap market, interest rate uncertainty can lead firms to substitute long-term for short-term financing. However, when swaps exist, there is a tendency for firms that expect their credit quality to improve to borrow short-term and use swaps to hedge interest rate risk. The model suggests that, while the demand for fixed for floating swaps is enhanced, the demand for floating for fixed swaps is reduced by the presence of asymmetric information. THE ACADEMIC LITERATURE ON optimal capital structure has traditionally focused on the percentage of a firm's capital that is financed with debt. More recently, academics have become concerned with the actual design of the debt instruments. Part of this interest in security design is probably due to recent innovations from Wall Street that provide firms with greater flexibility in the determination of their liability streams. Interest rate swaps are perhaps the most popular of these innovations. These transactions, which are described in more detail in Section I, allow short-term borrowers to reduce interest rate exposure and allow long-term borrowers to transform fixed-rate loans into floating-rate loans. The interest rate swap market was introduced in 1982 and grew to over one trillion dollars worth of swapped debt outstanding within about seven years. This paper provides one explanation for the growing popularity of these transactions. The paper builds on an idea that was originally developed by Flannery (1986) who showed that in the absence of interest rate uncertainty there is a tendency for borrowers with private information to prefer short-term loans. This tendency arises because those borrowers with the most favorable information prefer not to be locked into a fixed borrowing rate, since they expect to be able to borrow under more favorable terms in the future when their information is publicly revealed. This argument implies that the more

Abstract: LIBOR is the London Interbank Offered Rate: a measure of the interest rate at which large banks can borrow from one another on an unsecured basis. LIBOR is often used as a benchmark rate�meaning that the interest rates that consumers and businesses pay on trillions of dollars in loans adjust up and down contractually based on movements in LIBOR. Investors also rely on the difference between LIBOR and various risk-free interest rates as a gauge of stress in the banking system. Benchmarks such as LIBOR therefore play a central role in modern financial markets. Thus, news reports in 2008 revealing widespread manipulation of LIBOR threatened the integrity of this benchmark and lowered trust in financial markets. We begin with a discussion of the economic role of benchmarks in reducing market frictions. We explain how manipulation occurs in practice, and illustrate how benchmark definitions and fixing methods can mitigate manipulation. We then turn to an overall policy approach for reducing the susceptibility of LIBOR to manipulation before focusing on the practical problem of how to make an orderly transition to alternative reference rates without raising undue legal risks

Abstract: Different anomalies have appeared in the interest rate market after the burst of the credit crunch. A wide wedge has opened between the market quotes of Forward Rate Agreements and their standard spot Libor replication, and large Basis Spreads have appeared for exchanging floating payments with different tenors. Here we tackle these issues under two aspects.In Part 1 we focus on issues of direct interest to market practitioners. We show that the gap between FRA rates and their spot Libor replication can be explained by using the quoted Basis spreads. Then we explain the market patterns of the Basis spreads by modeling them as options on the credit worthiness of the counterparty. We also investigate analytically the FRA market payoff.In Part 2 we study the mathematical representation of the interest rate market in the post-crisis reality. We introduce credit risk at market level, allowing for no-fault standard rule and collateralization. We use subfiltrations to model Libor rates, which now embed relevant credit risk although no default event is possible on Libor itself. We compute change of numeraire and convexity adjustments for collateralized derivatives tied to risky Libor.

Abstract: Empirical analysis in this study examines factors that explain the use of interest rate swaps by nonfinancial firms in the Standard & Poor's 500. Consistent with asymmetric information and agency cost theories, firms with significant expected financial distress costs use swaps to transform short-term debt into long-term fixed-rate debt. Debt maturity structure, but not interest rate sensitivity, is significant in the decision to use a swap. Credit quality differentials or expectations of improving financial prospects are not significant in distinguishing among swap users.