Discussion: Who Uses Interest Rate Swaps? A Cross-Sectional Analysis

Discussion: “Who Uses Interest Rate Swaps? A Cross-Sectional Analysis” CATHERINE M. SCHRAND* In recent years, there have been numerous empirical stud...
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Discussion: “Who Uses Interest Rate Swaps? A Cross-Sectional Analysis” CATHERINE M. SCHRAND*

In recent years, there have been numerous empirical studies of derivatives use because of new data availability that resulted from requirements for annual report disclosures about derivatives activities of nonfinancial firms (Financial Accounting Standards Board Statements Nos. 105 and 119). Many of these studies test predictions from models of optimal hedging. These models suggest that the use of derivatives to reduce volatility in cash flows is optimal, even though it is costly, when the firm faces even greater exogenous or endogenous costs associated with cash flow volatility. Each of the models assumes the existence of a capital market imperfection that makes cash flow volatility costly. A common approach to testing these models is to examine the cross-sectional variation in the characteristics of firms that use derivatives (or use more derivatives). The explanatory variables represent firm characteristics that the author predicts are related to the proposed costs of volatility that the firm can reduce by hedging. “Who Uses Interest Rate Swaps? A Cross-sectional Analysis,” by Gnanakumar Visvanathan, fits into this general category of studies that test theories of optimal hedging. Other related studies examine the characteristics of firms that use any type of derivative-interest rate, foreign exchange (FX), or commodity-based instruments (e.g., Mian [ 19961; Guay [ 19971; Dolde [ 19931). In addition, some studies restrict their analysis to particular types of instruments, such as FX derivatives, or commodity derivatives including gold or oil and gas products (Geczy, Minton, Schrand [ 19971; Tufano [ 19961; Haushalter [ 19971). Like this paper. there are many studies that specifically examine interest-rate risk management. However, most of the existing research in this area focuses on the financial institutions industry because call report (regulatory) data have provided information about the use of derivatives by financial institutions since the mid- 1980s. By examining the use of interest rate instruments by nonfinancial firms that face different interestrate risk problems than financial institutions, this paper makes a contribution to the literature on the use of derivatives for interest rate risk management. The title of the paper implies that its focus might be on why firms use interest rate swaps rather than other interest rate derivatives to manage interest rate risk; however, the scope of the paper is broader than that. This paper tests theories about interest rate risk management, in general. For large nonfinancial firms, swaps are the most commonly used interest rate risk management tool. The fact that nonfinancial firms use swaps rather than other instruments is consistent with the models *University of Pennsylvania

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that this paper examines which claim that firms use swaps to hedge debt-related payments. Swaps are different from exchange-traded interest rate products because the terms are customized. Although customization is costly, it provides the benefit of reducing basis risk associated with exchange-traded products. The costs of basis risk are likely to outweigh the costs of customization when the magnitude and timing of the expected future cash flows is relatively predictable, and the cash flows that the firm is hedging extend over a long period. Debt-related payments are predictable with respect to amount and timing, and the time until debt maturity can be sufficiently long to warrant the costs of customization. Unfortunately, very few nonfinancial firms use exchange-traded interest rate products, such as futures, in isolation to manage interest rate risk. Therefore, the paper is unable to provide any statistical tests of whether the type of instrument that a firm uses to manage interest rate risk is correlated with the source of interest rate risk. The paper tests several theories of optimal hedging, each with its own predictions about the characteristics of firms that will use derivatives to hedge interest rate risk. Although testing multiple theories adds to the richness of the paper, it also complicates the analysis. In this discussion, I focus on the tests of the use of fixed-rate swaps. The models that attempt to explain the use of fixed-rate swaps, broadly speaking, assume that, in the absence of agency costs or information asymmetry between managers and creditors, the firm’s optimal debt choice is to have net debt payments that are fixed with respect to interest rate changes (or long-term fixed-rate debt). However, because of some market imperfection (e.g., information asymmetry or agency problems), long-term (fixed-rate) debt is exogenously or endogenously more costly than short-term (variable rate) debt for some firms. These firms take on shortterm debt to solve the information or agency problems, but short-term debt creates interest rate risk. Swaps are used to hedge this resulting risk. The models that fall into this broad category include Flannery (1986), Diamond (1991), Titman (1992), and Wall (1989). These models are based on three critical assumptions. First, they assume that short-term debt leads to a higher volatility in future cash flows than long-term debt. This assumption, however, is only reasonable with respect to the cash flows on the debt itself. The volatility of the net cash flows of the firm will not necessarily be higher just because a firm uses short-term (or variable rate) debt rather than longterm (or fixed-rate) debt. The sensitivity of the firm’s net cash flows to interest rate changes depends not only on the sensitivity of the debt-related cash flows, but also on the interest rate sensitivity of the cash flow returns to the firm’s unlevered assets. The second critical assumption of the models is that additional volatility created by the use of short-term debt is costly. The existing literature on optimal hedging has identified several capital market imperfections that create costs of volatility (e.g., Smith and Stulz [1985]; Froot, Scharfstein, and Stein [1993]). Note that these theories assume that capital market imperfections make volatility costly, while the theories tested in this paper assume that some capital market imperfection

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makes the choice of short-term debt combined with swaps less costly than fixedrate debt. Both types of capital market imperfections are necessary to predict that a firm will optimally use swaps. Thus, the empirical analysis must simultaneously attempt to control for these various market imperfections. Finally, these models assume that there are no other motivations for choosing long-term (fixed-rate) versus short-term (variable rate) debt such as those examined in the debt-maturity-choice literature. All firms that the models predict will use swaps are also assumed to prefer fixed-rate debt ex ante. The quality spread explanation (Bicksler and Chen [1986]) for the use of interest rate derivatives also fits into the category of models that assumes that fixed debt payments are optimal, but that the lowest-cost strategy to achieve these payments is to take on short-term debt and swap the resulting interest rate exposure. The quality spread argument acknowledges that firms can obtain synthetic fixedrate debt at a lower rate than the rate on long-term debt. Therefore, firms will use swaps to reduce the cost of debt. However, this prediction holds only if, in the absence of a quality spread differential, the firm prefers long-term debt to shortterm debt. Such an exogenous assumption is similar to that presented in the other models of optimal hedging with fixed-rate swaps. The assumption that firms will use fixed-rate swaps in combination with shortterm debt, conditional on an ex ante decision that (fixed-rate) net debt payments are optimal is critical for designing effective tests of the models of optimal swaps use. The tests must identify firms that ex ante prefer fixed debt payments because short-term debt creates volatility and this volatility is costly. In addition, other factors that affect a firm’s debt maturity choice decision need to be considered to predict which firms prefer fixed debt payments. Conditional on identifying these firms, the paper can test the proposed theories of swaps use by examining which firms achieve fixed-rate financing by using fixed-rate debt and which firms achieve a similar outcome synthetically by using a combination of short-term debt and swaps. Although it is necessary for testing the proposed models of swaps use, it is not easy to identify firms that ex ante prefer fixed-rate debt. To determine whether a firm meets this criterion, the tests need to consider three firm-specific factors: 1. The firm’s interest-rate sensitivity on its unlevered assets, 2. The firm’s incentives to hedge this underlying interest-rate sensitivity, and 3. The firm’s other incentives with respect to debt maturity choice as proposed in Barclay and Smith (1995), Titman and Wessels (1988), or Opler and Titman ( 1 996).

This paper does an admirable job of trying to control for these factors in the swaps-use decision, but the empirical task is difficult for several reasons. First, empirical proxies for the underlying interest rate sensitivity of a firm’s unlevered assets are, at best, weak. This study measures interest rate sensitivity by regressing quarterly per share earnings before interest and taxes on the 10-year T-bond rate for that quarter for each firm over the 1984-1992 period. The estimated coefficient

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on the T-bond rate from this regression is the measure of the firm’s interest rate sensitivity. Although this approach allows for a firm-specific measure of interest rate sensitivity, the trade-off is that it assumes that a firm’s interest rate sensitivity is relatively constant over the sample period. In addition, the coefficient measures only the sensitivity to rate changes that are observed during the period; it does not measure the sensitivity to possible (but unrealized) interest rate environments. The result is a relatively noisy measure of interest rate sensitivity. Second, empirical proxies for the “theoretical” incentives for hedging volatility, in general, and for the “theoretical” incentives for choosing synthetic fixedrate debt (short-term debt plus swaps) rather than fixed-rate debt are similar. In other words, many of the proxy variables that are useful as control variables for a firm’s debt maturity choice and incentives for hedging (conditions 2 and 3 above) are the same proxy variables that are useful to test the models of the optimal use of swaps. For example, empirical analyses of debt maturity choice have shown that a firm’s decision is related to its market-to-book ratio, future abnormal earnings, industry membership, market value, and debt-to-equity ratio (DE). One theory of swaps use suggests that “firms with better future prospects” are likely to use swaps and short-term debt to achieve synthetic fixed-rate debt. If abnormal earnings are a proxy variable for “better future prospects,” then it is empirically difficult to identify whether abnormal earnings drive the debt maturity choice or the decision to use short-term debt and swaps to achieve fixed-rate financing. Similar problems arise related to proxy variables for growth opportunities (as measured by the market-to-book ratio) and expected financial distress costs (as measured by the debtto-equity ratio and bond ratings). It is unclear whether the significant coefficients on these variables are related to debt maturity choice or swaps use. The third difficulty in designing effective tests of these models is simply one of data availability. Although the author has done an excellent job of finding (and refining) the sample of swaps users, the sample size is relatively small. This is a problem for the empirical tests because of the importance of trying to condition the analysis on a firm’s debt maturity choice. With a larger sample size, one could partition the sample to mitigate some of the issues related to identifying firms that ex ante prefer fixed-rate debt. However, such partitions are almost impossible given the relatively small number of firms with available data on swaps use. Because of the difficulties with designing empirical tests that control for the condition that firms ex ante prefer fixed-rate debt, the results of the empirical analysis should be interpreted with this limitation in mind. Despite this caveat, the paper provides an interesting and informative analysis of the use of interest rate instruments that takes into account a firm’s debt maturity choice and incentives for hedging. Participants at the conference asked about other incentives for swaps use besides those examined in this paper. For example, participants questioned motivations for using swaps to reduce volatility in accounting earnings (rather than cash flows) and tax incentives for entering into and terminating swaps. The use of swaps and short-term debt might also circumvent covenant violations that are more often

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included in long-term debt contracts. This explanation for the use of short-term debt and swaps in the presence of the debt covenants is similar to the models that assume that firms prefer to borrow long term, but that borrowing short term and swapping the resulting interest rate exposure is less costly than borrowing long term. In addition, participants noted that the paper ignores the notion that some firms might be speculating on interest rates, and speculation might explain the simultaneous use of both fixed and variable-rate swaps. Participants also discussed the potential informativeness of the new Securities and Exchange Commission (SEC) disclosure rules for derivatives (market risk) and the forthcoming accounting standard for derivative instruments. The SEC disclosures are effective for annual financial statements for firms with fiscal year ends after June 15, 1997. As disclosures and data availability improve, studies of derivatives use will be able to address some of the limitations noted in this paper. REFERENCES

Barclay. M. J., and C. W. Smith. 1995. “The Maturity Structure of Corporate Debt.” Journal ofFinance SO (June): 609-63 I . Bicksler, J., and A. H. Chen. 1986. “An Economic Analysis of Interest Rate Swaps.” Journal of Finance 41 (July): 645-655. Diamond, D. W. 1991. “Debt Maturity and Liquidity Risk.” Quurterly Journal of Economics 106 (August): 709-737. Dolde, W. 1993. “Use of Foreign Exchange and Interest Rate Risk Management in Large Firms.” Working Paper, University of Connecticut. Financial Accounting Standards Board. 1990. Stutemerrt cd Financial Accounting Standards No. 105: Disclosure of’ Injormution ubout Financial Instruments with Of-Balance-Sheet Risk and Financial Instrunrents with Concentrations of Credit Risk. Stamford, Conn.: FASB. -. 1994. Stiitement of Finunciul Accounting Sttindurds N o . 119: Disclosure about Derivative Finuncitil Instrunrents and Fuir Vulue of Finurrciul Instruments. Stamford, Conn.: FASB. Flannery. M. J. 1986. “Asymmetric Information and Risky Debt Maturity Choice.” Journal of Finance 4 I : 19-37. Froot, K., D. Scharfstein, and J . Stein. 1993. “Risk Management: Coordinating Investment and Financing Policies.” Journal of’ Finance 48: 1629-1658. Geczy, C., B. A. Minton. and C. Schrand. 1997. “Why Firms Use Currency Derivatives.” Journal of Finance 52:1323-1354. Guay, W. R. 1997. “The Impact of Derivatives on Firm Risk: An Empirical Examination of New Derivative Users.” Working Paper, University of Rochester. Haushalter, G. D. 1997. “The Role of Corporate Hedging: Evidence from Oil and Gas Producers.” Working Paper, University of Oregon. Mian, S. L. 1996. “Evidence on Corporate Hedging Policy.” Journal of Finuncial and Quantitative Analysis 3 1:419439. Opler, T., and S. Titman. 1996. “The Debt-Equity Choice.” Working Paper, The Ohio State University. Smith, C. W., and R. Stulz. 1985. “The Determinants of Firms’ Hedging Policies.” Journal ofFinancia1 and Quantitutive Analysis 28:391-405. Titman, S. 1992. “Interest Rate Swaps and Corporate Financing Choices.” Journal of Finance 47 (September): 1503-15 16. Titman, S., and R. Wessels. 1988. “The Determinants of Capital Structure Choice.” Journal ofFinance 43 (March): 1-19. Tufano, P. 1996. “Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry.” Journal of Finance 51:1097-1137. Wall, L. 1989. “Interest Rate Swaps in an Agency Theoretic Model with Uncertain Interest Rates.’’ Journal ojBanking and Finance 13 (May): 261-70.

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