Abstract: We develop and test a simple model of a firm's optimal debt maturity and its demand for interest rate swaps using 1994 data of over 4000 nonfinancial corporations. As in other models of derivative use, ours predicts a systematic relationship between a firm's swap position and the interest-sensitivity of its cash flow. We test this by estimating the cross-sectional relationship between a firm's swap position and: (1) the amount of short-term and floating-rate debt in its capital structure; and (2) the interest-sensitivity of its EBITD. We find strong evidence that firms use swaps to hedge interest rate risk arising from debt obligations but little evidence that they hedge interest rate risks from operating income. Consistent with theories of swap use (Arak et al., 1988, Wall, 1989, and Titman, 1992), our model also predicts that firms that avoid using swaps because of "transactions costs" issue less short-term debt than swap users, since the former are unable to hedge the resulting interest rate risk. We find this to be the case.

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