Interest Rate Swaps: Risk Exposure And Financial Disclosure

Abstract

In recent years, the trading of interest payments on debt obligations has become a major form of off-balance sheet financing. As swaps have increased in dollar volume, the amount of financial disclosure about these instruments has remained nonexistent or minimal. Yet, even with a lack of financial information available to evaluate swaps, previous analyses of swaps have always focused on their positive aspects. Our analysis finds there are negative aspects to swaps that need to be considered. The issues of lack of financial disclosure, unfavorable changes in risk exposure as well as questions about risk evaluations of firms involved in swaps are all related to the negative aspects of swaps. These issues are considered here. It is concluded that although there are advantages to swaps, these advantages are intrinsic to the instrument itself rather than to the alleged arbitrage profits. Furthermore, an example is used to illustrate how a firm’s risk exposure can be altered by a swap agreement. The ability of the market to evaluate the change in this risk may be hampered by lack of financial disclosures.