Abstract
The pricing of interest rate swaps is examined in the presence of asymmetric information between firm owners and creditors. A fairly standard version of Rothschild and Stiglitz (1976) is considered. A firm borrowing short-term is exposed to an interest rate risk. It can attain full insurance to this risk by borrowing long-term, or it can insure itself partially by borrowing short-term, and swapping a fraction of the nominal amount to fixed rate payments. If firms' credit quality and interest rate risk tolerance are correlated, creditors can use the swap spread as a screening device. The model is consistent with observed market rates, which are difficult to recover with standard measures of risk.