Borrowing cost reduction by interest rate swaps – an option pricing analysis

Interest rate swaps generally involve two firms with different credit ratings. A quality spread differential (QSD) is observed to exist at different maturities for firm debts with different credit ratings. The quality spread differential allows two firms with 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. Our results show that the quality spread differential can be explained by the differences in leverage and volatility. Thus two firms with different leverage and the volatility of earnings asset value will benefit from interest rate swaps. However, it is found that the duration within which the QSD exists is limited by the values of the leverage and the volatility of two firms. In conclusion, this paper shows that interest rate swaps can help the firms to lower borrowing costs without necessarily relying on the arbitrage asserted by existing literature.