Interest Rate Swaps: An Alternative Explanation

n The interest rate swap market, first developed in 1982, had an estimated annual volume of more than $360 billion in 1987.1 Various reasons have been given for the existence and growth of the market, ranging from comparative advantage arguments to agency cost explanations to tax and regulatory reasons. However, each of the explanations is in some way inadequate in explaining the phenomenal growth of the market. Prior to the introduction of swaps, the only instruments available to borrowers were long-term fixed rate, long-term floating rate, and short-term debt. The combinations that were possible with those instruments are shown in Exhibit 1. The introduction of swaps brought additional options to borrowers. When combined with short-term borrowing in the credit markets, swaps enable borrowers to fix the risk-free component of their interest costs while allowing the credit risk components to fluctuate. This ability to provide borrowers with previously unattainable alternatives is the characteristic that makes swaps a true, and probably enduring, financial innovation.