The Market Reaction to the Strategic Use of Interest Rate Swaps
Michael W. Faulkender
University of Maryland - Robert H. Smith School of Business
Nicole Thorne Jenkins
University of Kentucky - Von Allmen School of Accountancy, Gatton College of Business and Economics
Mellon Capital Management
We investigate the market's response to earnings generated from changes in current interest rate swaps. In general, we find that firms experience significantly negative market reactions when using swaps in steep term structure environments to meet expectations. Upon closer inspection we find that firms that meet expectations and use income decreasing swaps arrangements are responsible for the majority of the apparent penalty. Firms that swap floating for fixed rates - pay more interest expense today and less in the future - receive a significantly larger market premium then those firms that swap fixed for floating - pay less interest expense today and more in the future. Our results indicate that even though swaps are arranged as zero NPV transactions, there are specific structures that affect firm value in predictable ways. Overall, the market appears to appropriately identify and price the strategic use of swaps to hedge cash flow risk versus meeting market expectations.
Number of Pages in PDF File: 38
Keywords: Earnings Management, Interest Rate Swaps, Derivatives
JEL Classification: M41, M43, E43working papers series
Date posted: September 15, 2006
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