Monte Carlo Simulation Analysis on the Costs Reduction Argument of Interest Rate Swaps
AbstractThis paper develops a Monte Carlo simulation model based on contingent claims theory to evaluate the coupon interest that should be paid by the fixed and floating rate default risky corporate debts. The model improves the Black-Scholes-Merton analysis on firm’s liabilities by analysing the coupon paying debts in a variable default-free interest rate environment. The simulation results show that there exist comparative advantage between firms in the fixed and floating rate debt markets, which comes from the firms’ balance sheet structure and the nature of business. As such, interest rate swaps can benefit both participating firms for reasons other than market inefficiencies.
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