Discussion
Interest Rate Swaps and Corporate Default by Jermann and Yue
Xiaoji Lin
Ohio State University
Minnesota Macro Asset Pricing Conference
May 10, 2013

Summary of the Paper
Interest rate swaps in a general equilibrium model
Countercyclical idiosyncratic volatility and in‡ation risk important for:
1 …rms being …xed-rate payers
2 the negative relation between swap positions and the term spread

Summary of the Paper
Interest rate swaps in a general equilibrium model
Countercyclical idiosyncratic volatility and in‡ation risk important for:
1 …rms being …xed-rate payers
2 the negative relation between swap positions and the term spread

Summary of the Paper
Interest rate swaps in a general equilibrium model
Countercyclical idiosyncratic volatility and in‡ation risk important for:
1 …rms being …xed-rate payers
2 the negative relation between swap positions and the term spread

Summary of the Paper
Interest rate swaps in a general equilibrium model
Countercyclical idiosyncratic volatility and in‡ation risk important for:
1 …rms being …xed-rate payers
2 the negative relation between swap positions and the term spread

Outline
1
Model
2
Mechanism
3
Comments

The Model
Timeline of the model w/t swaps

The Model
Timeline of the model w/t swaps
Tension between long term projects and short term debt

The Model
Timeline of the model with swaps

The Model
Timeline of the model with swaps
Interest rate swaps are used to reduce default risk

The Model
Firms’optimization problem max
B;s
P V ( output )( B ) debt ( B ) P V ( default cost )( B; s )
Firms optimally choose swaps to reduce default costs

Mechanism
Optimal swap position is determined by
1
2
Interest rate exposure
Productivity risk exposure
Aggregate productivity shocks
Countercyclical idiosyncratic volatility shocks
3
In‡ation risk exposure
(inf,prod)
1. Countercyclical idio vol is crucial for …rms being …xed-rate payers
E(swap)
Prod Inf+Prod Inf+Prod+ (inf,prod) All+CounterIdioVol
5.98
Corr(swap,TS) 0.24
-1.96
-1.37
0.33

Mechanism
Optimal swap position is determined by
1
2
Interest rate exposure
Productivity risk exposure
Aggregate productivity shocks
Countercyclical idiosyncratic volatility shocks
3
In‡ation risk exposure
(inf,prod)
1. Countercyclical idio vol is crucial for …rms being …xed-rate payers
E(swap)
Prod Inf+Prod Inf+Prod+ (inf,prod) All+CounterIdioVol
5.98
Corr(swap,TS) 0.24
-1.96
-1.37
0.33

Mechanism
Optimal swap position is determined by
1
2
Interest rate exposure
Productivity risk exposure
Aggregate productivity shocks
Countercyclical idiosyncratic volatility shocks
3
In‡ation risk exposure
(inf,prod) < 0
2. Negative (inf,prod) is crucial for corr(swap,TS) < 0
E(swap)
Prod Inf+Prod Inf+Prod+ (inf,prod) All+CounterIdioVol
5.98
-1.96
-1.37
0.33
Corr(swap,TS) 0.24
0.95
-0.92
-0.75

Swap Positions and Countercyclical Idiosyncratic Volatility
Bloom at al 2012 construct 21 measures of idiosyncratic time-varying uncertainty. 16 of them have positive correlations with swap positions.
15
Swap position
XS TFP volatility
0.6
10 0.55
5
0
0.5
0.45
-5
1993
0.4
2003 corr(% Swapped into …xed, XS TFP VOL) = 0.59 with p-value = 0.06

Swap Positions and Countercyclical Idiosyncratic Volatility
Bloom at al 2012 construct 21 measures of idiosyncratic time-varying uncertainty. 16 of them have positive correlations with swap positions.
15
Swap position
XS TFP volatility
0.6
10 0.55
5
0
0.5
0.45
-5
1993
0.4
2003 corr(% Swapped into …xed, XS TFP VOL) = 0.59 with p-value = 0.06

Swap Positions and Countercyclical Idiosyncratic Volatility
20
Swap pos ition
IQR W IT HIN FIRM T FP
0.35
10 0.3
0 0.25
- 10 0.2
corr(% Swapped into …xed, IQR within …rm TFP) = 0.63 with p-value =
0.04

Swap Positions and Countercyclical Idiosyncratic Volatility
20
Swap pos ition
Labor Prod Volatility
0.7
10 0.6
0 0.5
- 10 0.4
corr(% Swapped into …xed, Labor productivity shocks) = 0.58 with p-value
= 0.05

Swaps and Default
Interest rate swaps are used to reduce default risk
20
%Swapped into fix ed
BAA-AAA
7to10 y ear c orp y ld-10 y ear tr y ld
10
5
0
-5
1997 1998 1999 2000
Year
2001 2002 2003 2004 corr(Swap, 10-15 year corp yld- 10 year tr yld) = -0.28, p-value = 0.02
corr(Swap, 7-10 year corp yld- 10 year tr yld) = -0.18, p-value = 0.12

Swaps and Default
Interest rate swaps are used to reduce default risk
20
%Swapped into fix ed
BAA-AAA
7to10 y ear c orp y ld-10 y ear tr y ld
10
5
0
-5
1997 1998 1999 2000
Year
2001 2002 2003 2004 corr(Swap, 10-15 year corp yld- 10 year tr yld) = -0.28, p-value = 0.02
corr(Swap, 7-10 year corp yld- 10 year tr yld) = -0.18, p-value = 0.12

Swaps and Default
20
10
0
-10
1997
% swapped into fixed
7to10 year yld-10 year tr yld
3
2
1
0
2004

Swaps and Welfare
In the model: Value of swap usage is small.
Resource constraint:
Y = C + I
Default cost is wasted.
Welfare bene…t of interest swaps may be nontrivial. Swaps may have a wealth e¤ect for households?

Conclusion
Very nice and very interesting paper!
Model predictions consistent with the data
Would be nice to see additional tests of model mechanism.