Chapter 26 Managing Risk 691
bre44380_ch26_673-706.indd 691 09/30/15 12:09 PM
Inflation swaps allow a company to protect against inflation risk. One party in the swap receives
a fixed payment while the other receives a payment that is linked to the rate of inflation. In effect,
the swap creates a made-to-measure inflation-linked bond, which can be of any maturity.^29
You can also enter into a total return swap where one party (party A) makes a series of agreed
payments and the other (party B) pays the total return on a particular asset. This asset might be a
common stock, a loan, a commodity, or a market index. For example, suppose that B owns $10
million of IBM stock. It now enters into a two-year swap agreement to pay A each quarter the
total return on this stock. In exchange A agrees to pay B interest of LIBOR + 1%. B is known
as the total return payer and A is the total return receiver. Suppose LIBOR is 5%. Then A must
pay B 6% of $10 million, or about 1.5% a quarter. If IBM stock returns more than this, there will
be a net payment from B to A; if the return is less than 1.5%, A must make a net payment to B.
Although ownership of the IBM stock does not change hands, the effect of this total return swap
is the same as if B had sold the asset to A and bought it back at an agreed future date.
(^29) If the inflation swap involves only a single payment, it is known as a zero-coupon swap. If it provides a sequence of payments, each
linked to the rate of inflation, it is called a year-on-year swap.
26-6 How to Set Up a Hedge
There can be many ways to hedge a risk exposure. Some hedges are zero-maintenance: Once
established, the financial manager can walk away and worry about other matters. Other hedges
are dynamic: They work only if adjusted at frequent intervals.
The forward contract between Northern Refineries and Arctic Fuels, which we described
in Section 26-4, was zero-maintenance because each counterparty locked in the price of heat-
ing oil at $2.40 per gallon, regardless of the future path of heating-oil prices. Now we look at
an example where the financial manager will probably implement a dynamic hedge.
Hedging Interest Rate Risk
Potterton Leasing has acquired a warehouse and leased it to a manufacturer for fixed pay-
ments of $2 million per year for 20 years. The lease cannot be cancelled by the manufacturer,
so Potterton has a safe, debt-equivalent asset. The interest rate is 10%, and we ignore taxes for
simplicity. The PV of Potterton’s rental income is $17 million:
PV = ___^2
1.1
- _____^2
(1.1)^2 - ⋯ + __^2
(1.1)^20
= 17.0 million
The lease exposes Potterton to interest rate risk. If interest rates increase, the PV of the
lease payments falls. If interest rates decrease, the PV increases. Potterton’s CFO decides to
issue an offsetting debt liability:
PV (lease)
= $17 million
PV (debt)
= $17 million
Thus Potterton is long $17 million and also short $17 million. But it may not be hedged.
Simply borrowing $17 million at some arbitrary maturity does not eliminate interest rate risk.
Suppose the CFO took out a one-year, $17 million bank loan, with a plan to refinance the
loan annually. Then she would be borrowing short and lending long (via the 20-year lease),
which amounts to a $17 million bet that interest rates will fall. If instead they rise, her com-
pany will end up paying more interest in years 2 to 20, with no compensating increase in the
lease cash flows.