454 Planning and Forecasting
A cellular communications firm has sold a six-year variable rate bond,
where the interest payments are tied to the London Interbank Offered Rate
(LIBOR). When LIBOR rises, so too do the company’s interest payments.
When LIBOR falls, the firm’s interest payments fall. The company’s interest
payments are due twice a year, on the last days of February and August. The
firm raised $160 million this way. With competition holding cellular telephone
rates down, the firm worries that an increase in interest rates can wipe out all
profits. What is the appropriate hedge instrument?
The interest rate exposure is symmetric, ruling out options. The firm
needs an instrument that will pay it money when interest rates rise. Thus, the
firm should go short in either bond futures or for wards, or the firm should be
the fixed-rate payer in an interest rate swap. Since the cash f lows that the firm
is trying to hedge do not conform to those of any exchange-traded future, the
correct choice is narrowed to the over-the-counter instruments—a forward or
a swap. The firm must hedge twelve interest rate payments, two per year for six
years. Forwards are generally constructed to provide one payment only. Swaps
are designed to hedge multiple payments over longer terms. Thus, entering a
six-year interest rate swap as the fixed payer is the ideal hedge in this situation.
SUMMARY AND FINAL RECOMMENDATIONS
This chapter has presented the basics of risk management using derivatives. By
separating an asset’s value from its exposure, derivatives allow firms to ex-
change exposures without exchanging the underlying assets. It is much more
economical to transfer exposures, rather than assets, and thus derivatives have
greatly facilitated risk management. Derivatives are indeed powerful risk man-
agement tools, but in the wrong hands they can be dangerous and destructive.
It is essential that managers fully understand how much and under what condi-
tions derivatives will provide positive cash f lows or require cash outf lows. If it
is not absolutely clear when and how much the cash f lows will be, do not enter
the contract. Managers should strive to identify the nature, magnitude, and
size of their risk exposures. They can then match those exposures with coun-
tervailing positions in derivatives. Managers should never forget that their job
is to preserve value by reducing risk. The temptation to speculate should be
avoided. Don’t be greedy.
FOR FURTHER READING
Abken, Peter, and Steven Feinstein, “Covered Call Options: A Proposal to Ease Less
Developed Country Debt,” in Financial Derivatives: New Instruments and
Their Uses (Atlanta: Federal Reserve Bank of Atlanta, 1994).
Bernstein, Peter, Against the Gods: The Remarkable Story of Risk(New York: John
Wiley, 1998).