450 Planning and Forecasting
growing computer hardware companies. They borrowed extensively to finance
this growth. Currently on the books is a very large long-term variable rate loan.
Also on the books is a sizable amount of short-term debt. The managers of
Keating Computer have observed that they are dangerously exposed to interest
rate risk. If rates should rise, they will have to pay more in debt service on the
variable rate loan, and they will face higher interest rates when they roll over
their short-term debt. The company is currently profitable, but they worry that
rising interest rates can wipe out that profit. Since the company is planning an
equity offering in coming years, management is very concerned about the
prospect of reporting any losses over the near term.
One solution to Keating Computer ’s problem would be to refinance at
fixed interest rates. The transaction costs of refinancing, however, are sizable,
and the rates currently offered on long-term debt are not favorable. Entering
an interest rate swap is a better hedging strategy. The company should enter as
the fixed rate payer, which means they would be the variable rate receiver. As
interest rates rise, the company will make money on the swap, offsetting the
higher payments they must make on their own debt. Since swaps are over-the-
counter instruments, the company can tailor the terms of the swap so that the
hedge will be in force for the exact number of years it is needed. Moreover, the
notional principal can be tailored so that the money received when rates rise is
closely matched to the new higher debt service obligations.
Another Example
Kayman Savings and Loan holds most of its assets in the form of long-term
mortgages, mortgage backed securities, and 30-year Treasury bonds. The lia-
bilities of Kayman Savings are mostly short-term certificates of deposits.
Kayman has also sold some short-term commercial paper of its own. Stephen
Kayman, the president of Kayman Savings, suddenly realizes that they are in
the same precarious predicament as that of many savings and loans (S&Ls) that
went bust in the 1980s. Long-term fixed income instruments are more sensitive
to interest rates than short-term instruments. When interest rates rise, both
long-term and short-term instruments fall in value, but the long-term instru-
ments fall much more. Consequently, if interest rates should rise, the market
value of the S&L’s assets will fall farther than the market value of its liabili-
ties. When this happens, the S&L’s equity will be wiped out. The bank will be
bankrupt. Even if government auditors do not shut down the S&L, the institu-
tion will experience cash f low problems. The relatively low fixed interest rev-
enue from the long-term assets will not be enough to keep up with the rising
interest expenses of the short-term liabilities. What can Kayman do to protect
against the risk of rising interest rates?
The predicament faced by Kayman Savings is known as a “duration gap.”
The duration of the assets is greater than the duration of the liabilities. As
rates rise, equity vanishes. Kayman Savings needs a hedge that will pay off
when rates rise. Entering an interest rate swap as the fixed payer can close the