Interest rate swaps and corporate default

This paper studies firms’ usage of interest rate swaps in a model economy driven by aggregate productivity shocks, inflation shocks, and counter-cyclical idiosyncratic productivity risk. Consistent with empirical evidence, firms in the model are fixed-rate payers. Counter-cyclical productivity risk is key for this finding; inflation risk contributes to producing the opposite outcome. Also consistent with empirical evidence, swap positions are negatively correlated with the term spread, so that firms appear to be timing the market. In the model, swaps generate only small economic gains for the typical firm.