16975631 strategies for interest rate risk management

8/7/2019 16975631 strategies for Interest Rate Risk Management

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strategies for Interest RateRisk Management

Phillipe C. BurkeThis article highlights a few liability maTiagement strategies,using derivative products for domestic corporate end users. First, thisarticle examines the interest rate risk managem entprocess, concludingwith three basic points that a proactive financial manag er mightadopt: (1) the appropriate debt structure for a company is not static,but varies as the firm's revenue composition changes and as interest

rates follow their cyclical path, (2) a firm's deb t structure should beassessed on the basis ofthe present or m ark to market value of its debtportfolio, and (3) while every debt Tnanagement action embodies somerate view, a decision based on a range offorecasted rates that allowsfor rate volatility is likely to afford more flexibility and opportunitiesthan one tied to point estimates and break-even rate paths. The articlealso shows how a proactive debt manager might solve a dozen real-lifeproblems using d ifferent derivative products in various interest rateenvironments.This article examines several interest rate risk management

strategies for corporate liability managers, using interest ratederivative products (caps,floors,swaps, and swaptions). A workingknowledge of these sta ndard tools is assumed, thu s the focus here ison the practical use of the products in liability man agement undervarious managerial constraints and in different interest rateenvironments.The first part ofthe article sets the stage with a brief review ofthedebt managem ent process, sum marizing the principal decisions of aliability manager before highlighting the various approaches he orshe might us e. In the second part, strateg ies a re discussed by usingexamples of actual cases that a practitioner might encounter.^REVIEW OF THE DEBT MANAGEMENT PRO CESSDecis ionsExhibit 1 summarizes some of the key decisions faced by afinancial manager in his or her analysis of both new and ongoingliability ma nagem ent problems. These are, quite simply, the: (l)ratioof hedged to unhedged debt, (2) m aturity structu re (both the averagelife and dispersion the debt repayment flows over time), and (3)instrum ents to use (public and private issu es, derivatives, etc). Thediligent manager will periodically reassess how the existing liability

Phillipe C . Burke is a P rincipalin the Interest Rate and CurrencyRisk Management Group at Se-curity Pacific Merchant Bank inNew York City.

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Exhibit 1Key DecisionsThe appropriate debt structure for a company will vary over time, asthe firm's revenue composition changes, and as interest rates followtheir natural cycle. An active liability manager will address thefollowing debt structure issues on an ongoing basis:1. Approp riate percentage of fixed ra te debt and floating ra tedebt;2. Preferred debt maturities;3. Optimal debt instruments; and4. Desired timing of execution.structure supports the firm's earning activities as the company'sproduct mix changes and as interest ra tes fluctuate. How the man agerapproaches these issues, along with the timing of entry into themarket, will depend on his or her risk preference and his or herassessm ent of how hospitable the current in teres t rate environmentis . Some of these approaches are reviewed in the next section.Alternative ApproachesExhibit 2 highlights different approaches to the rate riskmanagem ent process. Each of these is addressed in t um .

Exhibit 2Alternative ApproachesEvery Debt Structure (fixed/floating mix, maturities) reflectsmanagement's risk tolerance and judgment of the interest rateenvironment. The following are examples of different liahilitymanagement approaches:O All Floating or All Fixed:All liabilities in short-term , floating rat e debt, or all habilities in fixedrate deht.D Random Risk Taking:Raise an equal mix of 3, 5, 7,10 , and 30-year debt whenever fundingis required. Matching A vemge Life versus Using a 30-Dayl30-Year Mix:Contrast funding long-term assets with long-term debt and short-term assets with short-term debt on the one hand, with a debtcomposition of some m ix of only 30-day com mercial paper and 30-yeardebt on the other.CJ Proactive Deht Management:Actively manage the market value of the debt portfolio given thecompany's rate exposure, rate outlook, and tolerance for rate risk.

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Strategies for Interest Rate Risk M anagem ent

For the managerwith 35 brilliantyears of careerrity, the "law oflarge numbers" willensure that the deci-sion to fix or to floatshould depend onfactors other thanperceived cost ad-vantages of short- orlong-term debt

All FloatinglFixed, With the jdeld curve sloping upward some80 percent ofthe tim e, one position has held that staying at the shortend of the yield curve will, on averag e, enable a company to achievea lower cost of funds. Moreover, some have added th at payingfixedforterm would also require a company to attra ct re luctan t investors whowill demand a *Tiquidity" premium not needed at th e sho rt end oftheissuing curve. On the other hand, those in favor of paying fixed forterm argue that floating rate debt is cheaper only in the first fewmon ths ofthe hedging horizon, and that th e cost today (i.e., the yieldcurve slope) is more than outweighed by the benefit of a lowervolatility in cash flow and earnings per s hare .Other issues aside, whether fixed or floating rate debt actuallydoes prove to be cheaper over time may be tested with a simpleexperiment: Take two companies t ha t are identical in every respectexcept tha t one funds itself at th e 3 Month Treasury Bill (3Mo TBiU)rate and the other at the 5 (or 10) year T reasu ry yield. Once launchedunsuspecting into the m arketplace, we can easily observe thei r ac tual(pre-tax) cash cost of debt over time.A 35 year historical review of Treasury Bill and Note yields showsthat the company that rolled over 3Mo TBiUs would have achieved acost of fund not statistically different from tha t ofthe company thathad fiixedfor 5 years, or for 10 years (ignoring c redit spreads).^With the appropriate disclaimer that p ast resu lts are no guaranteeof future retums, this outcome is nevertheless quite comforting,indicating as it does the absence of segm entation, liquidity premium s,or other inefficiencies in the Treasury market over the sampledperiod. For the m anager w ith 35 brilliant yea rs of career secu rity, the"law of large num bers" will ensure th at the decision to fix or to floatshould depend on factors other than perceived cost advantages ofshort- or long-term debt, such as the company's rate exposure, rateoutlook, and risk preference. For those with sh orte r fuses, the "law ofsmall numbers'* applies in that m ark et timing can have a significantimpact on both the cost of debt and ca reers.Random Risk Taking, Whenever a funding need arises, arandom risk taking firm will raise a balanced percentage of short-,medium-, and long-term debt, largely ignoring rate views, timingconsiderations, and rate exposure or average life targe ts. This strategyappears to have the greatest merits for a company that frequentlyaccesses the capital m arkets. In any one yea r, 10 to 15 percent of itsdebt structure is refinanced, thus allowing the firm to benefit fix>mlower rates should they arise, but never exposing much ofthe firm'soverall deht to a potential r at e hike. Over time, the company's cost offunds w ill follow a path not unlike th at of a moving average of inte res trates.Matching Average Lives vs a 30day/30yr Mix, This casecompares the strategy of funding assets with liabilities of similarmaturitiesf with th e more aggressive approach of selecting a liabilitymix with equal duration but a lower initial cost. For instance, inExh ib i t 3, afirmfaces the choice of funding a 5-yearasset with 5 year

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Phillipe C. Burke

Note ., . the risksofthe barbelledstrategy,..

debt at 9.5 percen t, or achieving a similar duration at a 50 basis point(bp) cost savings hy funding with a "barbelled" combination of 30-dayCommercial Paper (CP) and 30-year debt.No te, however, the risk s ofthe barbelled st rategy : (1) the 30-daypaper may roll over at a higher rate in a month's tim e, (2) the 30-yeardebt may have to be retired a t a lower rate (resulting in a capital loss)in 5 years, and (3) the marked-to-market value of the barbelledstructure (and hence the firm's net equity value) will be far morevolatile when inter est rates change.

Exhibit 3Matching Average Lives

Yield

10.0%9.50%9.0%8.0%

Yield Curve

3 Year 4 Year 5 Year " Matur i ty

Proactive Debt Management. At the h eart of this approach arethree principles:(l) The appropriate debt structu re for a company isnot static, but varies as the firm's revenue composition changes andas intere st ra tes (short rate s, long rates, yield curve slope) fluctuatecompetitive pressures on internally generated cash flow is one ofseveral factors to consider in determining the appropriate debtstructure to supp ort operations ;(2) A firm's debt struc ture should notbe assessed solely on the basis of cur rent cash costs of servicing deb t,bu t also shoxild reflect th e m arket value ofthe debt portfolio though



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Strategies for Interest Rate Risk Management

, . . the manageris now able to ac-tively reshape theappropriate interestsensitivity of thefirm's debt structureas the firm's assetand earnings mixevolves .. .

floating ra te debt may lack the dedsiveness of itsfixedrate counterpartin a rising-rate environment, consider the exposure of a high fixedcoupon payer in a falling rate environment, (3) While it is true thatevery deht management action (e.g. tofixsome percentage or not, tohedge out to 5 years ra the r th an 3, to use a cap in lieu of a swap)embodies some rate view, a decision based on a range of rates andallowing for rate volatility is hkely to afibrd more flexibility andopportunities than one tied to point estimates and break-even ratepaths.

Unde r this approach, a financial man ager continually reassess esthe mark et value of each pa rt of the firm's debt stru cture (e.g. callfeatures, hedges) and makes a judgement whether to realize thatvalue and put the resulting gain/loss to use given the compan/sinteres t ra te exposure, rate outlook, and tolerance for interest raterisk.ILLUSTRATIONSWith the growth in ma rket hqu idity and standardization to date,it is now possible for a financial manager to amend, shorten, blend,extend, sell-of, in briefremold his or h er firm*sstrea m of liability cashflows as so much clay in his or her hands . From a ra te risk managem entstandpoint, the important benefit is th at the ma nager is now able toactively reshape the appropriate interes t sensitivity of the firm's debtstructure as the firm's asset and earnings mix evolves and as ratesand the yield curve slope change. In thi s environm ent, some say, it isbest to speak softly and carry a big swap portfolio. However, the choiceof hedging instrum en t (w hether swap or option) will be driven in largepart by the firm's rate outlook and desired payoff characteristics.Some examples of this active habihty m anagemen t work are examinedin the m aterials t ha t follow.Target SwaptionSuppose a firm's targe tfixed5-year swap rate is 9 percent, 50bpsbelow current rates. Rather than simply waiting for rates to drop,consider selling off the right to receive a fixed rate of 9 percent fi-omyou for 5 years in, say, 6 mo nths' tim e, for a prem ium receipt of 50bps.If 5-year swap rates are below 9 percent in 6 months, the swaptionbuyer will exercise his or her option locking the firm into its targe trate, resulting in a fixing cost to the firm of 9 percent minus thealready collected premium of 50bps. But what if rates never drop?Waiting won't be of much help; having sold a Swaption, however, thepremium receipt coxild be used to buy a cap on part of the firm'sLondon In terbank Offered Rate (LIBOR) or CP funding cost agains tth at doomsday scenario of high ra tes . Meanwhile, the m anager cankeep selling Swaptions every 6 months until rates drop below 9percent, and use ihe premium to lower his or her floating rate cost.Time Swaption

Assimie th at prospectsforsignificantlower U.S. rates are beginning

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A rise in interest anda steepening in theyield curve are creat-ing opportunities tounwind or assignunwanted swaps atattractive gains, orat least smallerlosses...

to dim. Yet it is now clear tha t the man ager still needs one more 4-to 6-year swap for ra te protection or mat urity extension to top it off,despite the h igher rates. The manager can payfixedin a 5-yearSwaptoday at 9.5 percen t. With volatility picking up and the impliedforward curve steepening G>oth mak ing options dearer), the m anagercould simultaneously sell off the rig ht to cancel out ofthe last y ear oftha t Swap in 4 years, and also sell the right to extend th at Swap bya y ear in 5 years for a total of 6 years. For his or her indecisiveness,the option buyer will pay the m anag er 100bps up front or lower theSwap coupon. If this stra tegy sounds like it might have escaped froma lab in Transylvania, consider what happen s when the ash es settle :The manager is left paying either 9.19 percent for 4 years or 9.28percen t for 6 yearsnot a bad deal for a company tha t is indifferentbetween a 4, 5, or 6-year Swap today.Protecting Unrealized G ainsWith rates on the rise, a financia l manager may look for ways toprotect the unrealized gains in his or her firm'sfixed rat e liability (andhedge) portfolio, without compromising the firm's upside potentialshould all-in rates rise even further. The manager might buy aSwaption today, giving his or he r company the rig ht to receive fixedat around current rates , a right to be executed once at the end oftheyear. Pay, however, nothing today; instead, th e m anager uses his orher future buyout gain to pay for the premium . If rates are lower ina yearns time, he or she can execute the Swaption and defacto realizethe value ofthe hedge at today's high rates.If rate s a re higher, he or she can let the Sw aption expire unuse dand execute a buyout at th en prevailing higher rate s. As a result, noma tter where rates are in a year's time, the m anager will be able toexecute his or her buyout at a rate t ha t is at least a s high as it is today:He or she has protected most ofthe curre nt unrealized gain, and keptthe upside potential.Moreover, inste ad of paying "good" cash today to protect a futuregain, the man ager ha s used a portion ofthe buy out value ofthe Swapto pay the premium. N ote, moreover, th at (1) the m anager will wantto ensure that the option cc^t does not consume an unreasonablepercentage of his or her unreah zed gain, and (2) if he or she decidesto keep the swap in a year's time, the option premium could beamortized into his or her existing swap coupon to avoid a cashpayment on tha t date.Buyout of an Existing Low Coupon SwapA rise in intere st a nd a steepening in the yield curve are cre atingopportunities to unwind or assign unwanted swaps at attractivegains, or at least sm aller losses: as term ra tes rise, the m arket valueof dista ntfixedrate coupons on existing debt and sw aps will fiourishextravagantly. S waps, of course, may be unwound in pieces sm all andlarge (e.g., by averaging-in a first $25MM tranche out of a $50MMswap position), or in pieces long and short (e.g. by selling the las t 3



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Strategies for Interest Rate Risk Ma nagem entyears of a 7 year swap, where the biggest gain resides because of thesteepen ing yield curve).Suppose a swap had been acquired at 8.5 percent d uring kinderdays; now, in a 9.5 percent ra te environm ent, the m ana ger looks verysmug ind eed The position he or she proudly holds is equivalent tohaving bought a cap and sold a floor at 8.5 percent. A buyout (orcancellation) of the existing swap a t cu rren t ra tes of 9.5 pe rcent wouldne t a gain of 100bps pa (9.5 percent-8.5 percent). Before contemplatingearly retiremen t, the man ager should consider selling a 9.5 percentcap, ignoring floors all together, an d keeping your existing swap onthe books. Because the manag er would never buy afloorback in thiscase, he or she ends up earning a full cap premium. Th us, he or she isleft with the following outcomes: The s trategy out-performs a buyoutif rates rise past 9.5 percent-cap premixmi, (since the manager herelags the ma rket by lOObps+cap premium while the buyou t case lagsthe market by 100bps), and underperforms the buyout if rates dropbelow9.5percent-capprem ium(becauseabuyout converts the managerto a floating rate-lOObps while this cap alte rnativ e keeps him or herfixed at 8.5 percent less the premium earned). In both instances,however, thefirmis left exposed to rat es above 9.5 percent a problemth at can be addressed independently.

In both instances..the firm, is leftexposed to ratesabove 9,5 percent,.

Reversing a SwapLet us assume that sometime ago, after examining the firm'sintere st ra te exposure, a man ager entered into a swap to raise his orhe r overall hedged ratio, payingfixedat 8 percent for 10 years. A yearlater, rate s have risen to 10 percent, a large enough move to w arranta serious review of the firm's portfolio average hfe and to considerreahzing some imbedded values. The financial mana ger decides totake advantage of market volatility and to lock-in a portion of thegains, shorten maturities som ewhat, and raise, at the m argin, the mixof floating rate debt.In the process, the manager chooses to realize the handsome 2percent per annum (pa) gain in the existing 8 percent swap with aremaining 9 year life.Now rather than cancelling the 8 percent swap (with a 9-yearremaining hfe) and taking the profit up fix)nt,the m anager cunninglydecides to lock in th e gain by keeping the 8 percent swap outstandingand receiving a current market rate of 10 percent in a new 9-yearswap, thereby securing the m argin in the form of a 2 percent pa 9-yearannuity. As volatility eventually brings m arket rate s back to, say, 8percent, the 2 percent annuity can be realized by cancelling bothswaps and obtaining the present value of th at stream . Thus, he hasachieved the p resent va lue receipt of a 2 percent pa ann uity, realizedin a 10 percent environment, but discounted at th e curren t 8 percentmarket rate, resulting in a much higher PV amount th an if the sameannuity had been present valued and delivered in the 10 percentenvironment that prevailed when the "buyout" was engineered.Raising his voice over the mu rmu r of congratulations, he sagely notes

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. . . with the recentsigning ofthe latestbankruptcy billyswap market partici'pants are now ableto manage the n etinstead of aggregateexposure they haveto any one counter-. . .

that executing this "buyout" requires having 2 swaps outstandiinste ad of none in the case of a st anda rd cancellation: W ith two swand two cancellations (instead of one) comes an increm ental Bid/Ospread. B ut with the recent signing ofthe latest bankruptcy bill, swmarket participants are now able to manage the net insteadaggregate exposure they have to any one coiinterparty, lowering thcapital requirements and resulting pass-through costs in the casoffsetting swaps.M onetizing a Deep In The Money CallAs option stra tegies proliferate, some of us have found i t usefubru sh up on how to draw and use "payofi'diagrams"those quie t ligraphs depicting the profit and loss potential of different hedgstrategies. Suppose a firm has a 5-year, 12 percent bond thatcallable in 3 years at pa r, and is considering a Swaption to realizevalue of that call today, while rate s are s till low. If rates are belowpercent in 3 years , the bond is called and th e Swaption is exercispu tting the firm back a t 12 percen t. If rate s are above 12 percent,call and Swaption expire useless, leaving thefirmagain at 12 percThe call is thus monetized, quite sensibly indeed. A payoff diagrhowever may show tha t a F orward Swap in which the firm payspercent (less any floating rate spread) from years 3 to 5 can actuabe more desirable (see Exhibit 4). Both the Swaption and ForwaSwap generate income upfi'ont, bu t because th e 12 percen t call ishigh (in the the m oney), very little time value will be realized in Swaption sale, keeping the two premium s very close. If rates below 12 percent in 3 years, the firm calls tbe bond and the ForwSwap keeps it at 12 percent, as would have occurred with tSwaption. If rates are above 12 percent, the call expires, but tForward Swap holds a gain in the firm's favor, un like the SwaptiA payofT diagram can show th a t prem ium/gain tradeoff in b rilliatechnicolor. Note also th at Forw ard Swaps benefit from more liqum arkets than Swaptions, allowing more risk managem ent flexibiYield Curve Slope H edgeRemem ber when rates were low and th e yield curve was still fon it s face? As the term stru cture steepens from its 1989-90 lows, cost of yield curve sensitive hedges (e.g., caps, collars, forward swamay rise considerably, even ifboth sho rt and lon gra tes drop. Considthe following yield curve hedge: Afirmcould ente r into two forwSwaps to (1) receive 9.45 percen tfixedon $50MM firom1991 to 19and (2) pay 9.59 percent fixed on $ 15.44MM from 1991 to 2000. If bshort and long rates rise by say 20bps, the loss in (1) (on a largamount and shorter maturity) will be offoet by a gain in (2) (onsmaller amoun t and longer m aturity), and vice versa if rates droptandem . In other words, should rates generally drop, this str uctu


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Strategies for Interest Rate Risk Management

. . . some companiesare, quite sensibly,contemplating pur-chases of caps forrate protection andfloors to convert oldcollars into gleam,-ing new caps.

Monetizing the V alue of a Call Using aSwaption vs . a Forward Swap

sensitive hedge (e.g.. Cap) by the roughly $1.3MM gain resu lting fi:x>munwinding (1) and (2). Note also that because (1) and (2) both havestart dates one year hence, this structure will cause no cash outlay onth efirm'spart during the y ear it is implementing its hedging program.Out of the Money F loorsPositioning ahead of a bumpy ride down to lower short-term rates,some companies are, quite sensibly, contemp lating purcha ses of capsfor ra te protec tion and floors to convert old coUeirs into gleaming newcaps. Another dazzling strategy for participating in a ra te drop overthe next few months is the acquisition of an out ofthe moneyfloor.Forinstance, in a 9 percent ra te environment, the cost of a 5-yearfloorat6 percent on 3MoLIBOR barely shows up on the ra dar screen: say, 12bps or $120,000 on $100MM. If volatility rises to its recent historicalaverage within, say, 3 months' time and rates are unchanged, themarket will bid the instrument back at a 25 percent gain to thecompany. And if inte rest rate s drop by 25bps, in parallel m otion, theretu rn from such a sale rises to 50 percent. Meanwhile, the downsidecan never exceed the 12bp outlay at time zero. Of course, ratesprobably won't move in parallel fashion. In the above scenario, thegreatest return comes from the heightened value of the far-datedoptions imbedded in th efirm's5-year floor, but th e m anager could ju stas easily sell off any portion o fthe floor, selectively keeping th e restfor later use.Buying the Spread

In the last year, 2 and 3 year swap spreads have been in the lower3 percentile and 1 percentile of their historical distributions (for

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Phillipe C. Burke

. . . a hypotheticalcompany now (orsoon) could hold asizeable gain in aswap with a bankthat is rapidlyapproachingextinction.

several weeks). A truly chilling encounter, partly explained by adeceleration in the growth ofbanldng asset (loans) an d the authoritiesincreased reliance on T-Bills for refinancings. The re are sev eral waysto capitalize on this phenomenon, and three a re reviewed here. Fir stis the spread lock, a contract committing a company's hanker toreceive (and the oim pany to pay) afixedspread agreed upon today ina sw ap on, say, $100MM, for 3 yea rs, which wiU be entered into at anytime the firm so desires within the next 3 months. For a 3 monthcommitment, the spread may rise some 4.5bps above th at of a spottransaction, say, to 56hps. If spreads retu rn to their historical average(mid 70bps)in the next few m onths, m anage rs wiU have th e opportunityto enter into swaps w ith an imbedded gain of roughly $380,000 (whichmay he realized imm ediately). And with 3 year spread s in their lowerone percentile, the chances of down side losses are quite diminishedindeed.Another way of isolating the sp read opportunity alone is to payfixed in a 3 year swap beg inning today, and to tak e a long position in3 year Treasuries (in the cash or futures ma rkets), thereby eliminatinginterest rate risk.Finally a less tha n perfect option position m ight he constructed hy(1) buying a sw aption giving the firm th e right to pay the curren t twoyear swap rate for 1.5 years s tartin g in 6 m onths, and simultaneously(2) selling a six month Einropean put on the 2 year Treasury. Theattractiveness of this tra de is its low upfix)nt cost^roughly 4bps . Thedrawback, however, is that an option on a swap spread does notexactly equal an option on a swap minus an option on a Treasury.Pro tecting an Unr ealized G ain Held by a WeakCounterpartyA little house cleaning in the hedge portfolio shows that ahypothetical company now (or soon) could hold a sizeable gain in aswap with a bank th at is rapidly ap proaching extinction. With largepacks of its cred itors busily erecting brilliantly engineered gallows onits fix)ntlawn, the nearly eviscerated entity is grad ually drooping intothat grea t dark void ofreceivership. After a sHght twinge of queas iness,the company begins to attack the problem w ith a gush of enthu siasm ,exploring at first two non-swap alternatives: (1) it send s out to otherrelationship banks a requ est for quotes on a L etter of Credit to backany gain in the swap, and (2) it asks its existing swap counterparty tocollateralize the loss in the swap in question. Both altern atives arelikely to generate an eerie, almost haunting silence. There are,fortunately, three other (swap-driven) ways of warding ofif thistroublesome credit evU. One is to simply term inate the agreementwith the current coiinterparty, receive the buyout gain fi-om th atcounterparty, and re-estabHsh a new position with another, morecreditworthy, entity. Under the so-called "extingxiishment** taxdoctrine, a buyout payment is considered to not have a risen fix>m a"sale or exchange" of property, and such payment would thereforegenerate a n (immediate) ordinary income tax im pact.



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Strategies for Interest Rate Risk Ma nagem entA second choice, economically equivalent on a pre-tax basis , is forthe company to assign its rights and obligations under the currentswap to a third pa rty and once again receive a buyout gain (this timefrom the third party), and then re-establish a new position with acreditworthy e ntity.In this in stance of an assignm ent of an in-the-money swap positionto an unrelated third party, the buyout gain received by the company 11 prohahly be viewed as a "sale or exchange" of property, and willgenerate an (immediate) capital gain tax impact. Note, however, thatif the company believes th at the co unterparty's profile is not entirelywithout blemish, so will most other sober third parties . Thus, findingone willing to buy out th e company*s position at 100 cents on the dollarmay require a sm all amoimt of divine intervention. (However, in theopposite situation, that is if there is a loss in a swap with somecoun terparty with a dreadful disposition, the hedge could be in quitea bit of demand these days!)A third alternative is for the original counterparty to assign the

swap position with th e company to a third (creditworthy) entity of thecompan/s choice, who will henceforth face the company in theexisting swap out to m aturity. In all hkelihood, the existing and th enew coun terparties' mea sure of the company's buyout gain will differby the market's bid/offer spread. As a result, the assignment willusually resu lt in the existing counterparty paying the lower measureof the buyout gain to th e new counterparty and the company bridgingthe difference up to the higher measure with a payment to the newcounterparty. Bid/offers aside, such an assignment will probablyresult in no tax consequence at all to th e company.^

. . . the distinguish'ing characteristic ofproactive interestrate risk managers istheir willingness toactively manage theunrealized gains andlosses that a debtportfolio will inevita-blygenerate, as in-terest rates changeand as time passes.

CONCLUSIONAs illustrated in this article, the distinguishing characteristic ofproactive intere st r ate risk m anagers is their w illingness to activelymanage the unrealized gains and losses that a debt portfolio willinevitably gene rate, as interest ra tes change and as time passes. Thisactive, hands-on approach to hability managem ent differsfromtradinga balance sheet; running a speculative futures account wouldundoubtedly be more effective for the latt er purpose. Instea d, as theexamples sought to show, a proactive debt manager will selectivelytake advantage of opportunities offered by today's volatile rateenvironment w ithin certain co nstraints of rate exposure, outlook, andrisk tolerance.NOTES

1. Though simplified for eajse of exposition, all of the caBes are based on actualproblems the autho r encountered during the last year. Fun ding considerations areset aside; the focus is on man aging in terest r ate risk.2 . See "The Historical Cost of Fixed Vs. Floating Rate Deb t' by Jack B uchmiller andJeff Pearsa ll, (September 1988) Security Pacific B ank, New York.3 . A good article on these tax issues appeared in the T ax Law Review, Volume 43,Number 3.

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16975631 strategies for interest rate risk management

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