strategies for Interest Rate
Risk Management
Phillipe C. Burke is a Principal
in the Interest Rate and Currency
Risk Management Group at Se-
curity Pacific Merchant Bank in
New York City.
Journal of Corporate Accounting and Finance/Spring 1991
Phillipe C. Burke
This article highlights a few liability maTiagement strategies,
using derivative products for domestic corporate end users. First, this
article examines the interest rate risk managementprocess, concluding
with three basic points that a proactive financial manager might
adopt: (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 debt structure should be
assessed on the basis ofthe present or mark to market value of its debt
portfolio, and (3) while every debt Tnanagement action embodies some
rate view, a decision based on a range offorecasted rates that allows
for rate volatility is likely to afford more flexibility and opportunities
than one tied to point estimates and break-even rate paths. The article
also shows how a proactive debt manager might solve a dozen real-life
problems using different derivative products in various interest rate
environments.
This article examines several interest rate risk management
strategies for corporate liability managers, using interest rate
derivative products (caps,floors,swaps, and swaptions). A working
knowledge of these standard tools is assumed, thus the focus here is
on the practical use of the products in liability management under
various managerial constraints and in different interest rate
environments.
The first part ofthe article sets the stage with a briefreview ofthe
debt management process, summarizing the principal decisions of a
liability manager before highlighting the various approaches he or
she might use. In the second part, strategies are discussed by using
examples of actual cases that a practitioner might encounter.^
REVIEW OF THE DEBT MANAGEMENT PROCESS
Decisions
Exhibit 1 summarizes some of the key decisions faced by a
financial manager in his or her analysis of both new and ongoing
liability management problems. These are, quite simply, the: (l)ratio
of hedged to unhedged debt, (2) maturity structure (both the average
life and dispersion the debt repayment flows over time), and (3)
instruments to use (public and private issues, derivatives, etc). The
diligent manager will periodically reassess how the existing liability
317
 Phillipe C. Burke

Exhibit 1
Key Decisions
The appropriate debt structure for a company will vary over time, as
the firm's revenue composition changes, and as interest rates follow
their natural cycle. An active liability manager will address the
following debt structure issues on an ongoing basis:
1. Appropriate percentage of fixed rate debt and floating rate
debt;
2. Preferred debt maturities;
3. Optimal debt instruments; and
4. Desired timing of execution.

structure supports the firm's earning activities as the company's

product mix changes and as interest rates fluctuate. How the manager
approaches these issues, along with the timing of entry into the
market, will depend on his or her risk preference and his or her
assessment of how hospitable the current interest rate environment
is. Some of these approaches are reviewed in the next section.

Alternative Approaches
Exhibit 2 highlights different approaches to the rate risk
management process. Each of these is addressed in tum.

Exhibit 2
Alternative Approaches
Every Debt Structure (fixed/floating mix, maturities) reflects
management's risk tolerance and judgment of the interest rate
environment. The following are examples of different liahility
management approaches:

O All Floating or All Fixed:

All liabilities in short-term, floating rate debt, or all habilities in fixed
rate deht.
D Random Risk Taking:
Raise an equal mix of 3, 5, 7,10, and 30-year debt whenever funding
is required.
• Matching Avemge 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 debt
composition of some mix ofonly 30-day commercial paper and 30-year
debt on the other.
CJ Proactive Deht Management:
Actively manage the market value of the debt portfolio given the
company's rate exposure, rate outlook, and tolerance for rate risk.

318 Journal of Corporate Accounting and Finance/Spring 1991

 Strategies for Interest Rate Risk Management

All FloatinglFixed, With the jdeld curve sloping upward some

80 percent ofthe time, one position has held that staying at the short
end ofthe yield curve will, on average, enable a company to achieve
a lower cost of funds. Moreover, some have added that payingfixedfor
term would also require a company to attract reluctant investors who
will demand a *Tiquidity" premium not needed at the short end ofthe
issuing curve. On the other hand, those in favor of paying fixed for
term argue that floating rate debt is cheaper only in the first few
months ofthe hedging horizon, and that the cost today (i.e., the yield
curve slope) is more than outweighed by the benefit of a lower
volatility in cash flow and earnings per share.
Other issues aside, whether fixed or floating rate debt actually
does prove to be cheaper over time may be tested with a simple
experiment: Take two companies that are identical in every respect
except that one funds itself at the 3 Month Treasury Bill (3Mo TBiU)
rate and the other at the 5 (or 10) year Treasury yield. Once launched
unsuspecting into the marketplace, we can easily observe their actual
(pre-tax) cash cost of debt over time.
A 35 year historical review of Treasury Bill and Note yields shows
that the company that rolled over 3Mo TBiUs would have achieved a
cost of fund not statistically different from that ofthe company that
For the manager hadfiixedfor 5 years, or for 10 years (ignoring credit spreads).^
with 35 brilliant With the appropriate disclaimer that past results are no guarantee
years of career of future retums, this outcome is nevertheless quite comforting,
rity, the "law of indicating as it does the absence of segmentation, liquidity premiums,
large numbers" will or other inefficiencies in the Treasury market over the sampled
ensure that the deci- period. For the manager with 35 brilliant years of career security, the
sion to fix or to float "law of large numbers" will ensure that the decision to fix or to float
should depend on should depend on factors other than perceived cost advantages of
factors other than short- or long-term debt, such as the company's rate exposure, rate
perceived cost ad- outlook, and risk preference. For those with shorter fuses, the "law of
vantages of short- or small numbers'* applies in that market timing can have a significant
long-term debt impact on both the cost of debt and careers.
Random Risk Taking, Whenever a funding need arises, a
random risk taking firm will raise a balanced percentage of short-,
medium-, and long-term debt, largely ignoring rate views, timing
considerations, and rate exposure or average life targets. This strategy
appears to have the greatest merits for a company that frequently
accesses the capital markets. In any one year, 10 to 15 percent of its
debt structure is refinanced, thus allowing the firm to benefit fix>m
lower rates should they arise, but never exposing much ofthe firm's
overall deht to a potential rate hike. Over time, the company's cost of
funds will follow a path not unlike that of a moving average ofinterest
rates.
Matching Average Lives vs a 30day/30yr Mix, This case
compares the strategy of funding assets with liabilities of similar
maturitiesf with the more aggressive approach of selecting a liability
mix with equal duration but a lower initial cost. For instance, in
Exhibit 3, afirmfaces the choice offunding a 5-year asset with 5 year

Journal of Corporate Accounting and Finance/Spring 1991 319

 Phillipe C. Burke

debt at 9.5 percent, or achieving a similar duration at a 50 basis point

(bp) cost savings hy funding with a "barbelled" combination of 30-day
Commercial Paper (CP) and 30-year debt.
Note.,. the risks Note, however, the risks ofthe barbelled strategy: (1) the 30-day
ofthe barbelled paper may roll over at a higher rate in a month's time, (2) the 30-year
debt may have to be retired at a lower rate (resulting in a capital loss)
strategy,.. in 5 years, and (3) the marked-to-market value of the barbelled
structure (and hence the firm's net equity value) will be far more
volatile when interest rates change.

Exhibit 3
Matching Average Lives

Yield
•

Yield Curve
10.0%
9.50%
9.0%
8.0%

"•Maturity
3 Year 4 Year 5 Year

Proactive Debt Management. At the heart of this approach are

three principles:(l) The appropriate debt structure for a company is
not static, but varies as the firm's revenue composition changes and
as interest rates (short rates, long rates, yield curve slope) fluctuate—
competitive pressures on internally generated cash flow is one of
several factors to consider in determining the appropriate debt
structure to support operations ;(2) A firm's debt structure should not
be assessed solely on the basis of current cash costs of servicing debt,
but also shoxild reflect the market value ofthe debt portfolio— though

320 Journal of Corporate Accounting and Finance/Spring 1991

 Strategies for Interest Rate Risk Management

floating rate debt may lack the dedsiveness ofitsfixedrate counterpart

in a rising-rate environment, consider the exposure of a high fixed
coupon payer in a falling rate environment, (3) While it is true that
every deht management action (e.g. tofixsome percentage or not, to
hedge out to 5 years rather than 3, to use a cap in lieu of a swap)
embodies some rate view, a decision based on a range of rates and
allowing for rate volatility is hkely to afibrd more flexibility and
opportunities than one tied to point estimates and break-even rate
paths.
Under this approach, a financial manager continually reassesses
the market value of each part of the firm's debt structure (e.g. call
features, hedges) and makes a judgement whether to realize that
value and put the resulting gain/loss to use given the compan/s
interest rate exposure, rate outlook, and tolerance for interest rate
risk.

ILLUSTRATIONS
With the growth in market hquidity and standardization to date,
it is now possible for a financial manager to amend, shorten, blend,
extend, sell-o£f, in briefremold his or herfirm*sstream ofliability cash
flows as so much clay in his or her hands. From a rate risk management
standpoint, the important benefit is that the manager is now able to
actively reshape the appropriate interest sensitivity of the firm's debt
structure as the firm's asset and earnings mix evolves and as rates
and the yield curve slope change. In this environment, some say, it is
best to speak softly and carry a big swap portfolio. However, the choice
, . . the manager ofhedging instrument (whether swap or option) will be driven in large
part by the firm's rate outlook and desired payoff characteristics.
is now able to ac- Some examples ofthis active habihty management work are examined
tively reshape the in the materials that follow.
appropriate interest
sensitivity of the Target Swaption
firm's debt structure Suppose a firm's targetfixed5-year swap rate is 9 percent, 50bps
as the firm's asset below current rates. Rather than simply waiting for rates to drop,
and earnings mix consider selling off the right to receive a fixed rate of 9 percent fi-om
evolves... you for 5 years in, say, 6 months' time, for a premium receipt of 50bps.
If 5-year swap rates are below 9 percent in 6 months, the swaption
buyer will exercise his or her option locking the firm into its target
rate, resulting in a fixing cost to the firm of 9 percent minus the
already collected premium of 50bps. But what if rates never drop?
Waiting won't be of much help; having sold a Swaption, however, the
premium receipt coxild be used to buy a cap on part of the firm's
London Interbank Offered Rate (LIBOR) or CP funding cost against
that doomsday scenario of high rates. Meanwhile, the manager can
keep selling Swaptions every 6 months until rates drop below 9
percent, and use ihe premium to lower his or her floating rate cost.
Time Swaption
Assimie that prospectsforsignificantlower U.S. rates are beginning

Journal of Corporate Accounting and Finance/Spring 1991

SZl
Phillipe C. Burke

to dim. Yet it is now clear that the manager still needs one more 4-
to 6-year swap for rate protection or maturity extension to top it off,
despite the higher rates. The manager can payfixedin a 5-year Swap
today at 9.5 percent. With volatility picking up and the implied
forward curve steepening G>oth making options dearer), the manager
could simultaneously sell off the right to cancel out ofthe last year of
that Swap in 4 years, and also sell the right to extend that Swap by
a year in 5 years for a total of 6 years. For his or her indecisiveness,
the option buyer will pay the manager 100bps up front or lower the
Swap coupon. If this strategy sounds like it might have escaped from
a lab in Transylvania, consider what happens when the ashes settle:
The manager is left paying either 9.19 percent for 4 years or 9.28
percent for 6 years—not a bad deal for a company that is indifferent
between a 4, 5, or 6-year Swap today.

Protecting Unrealized Gains

With rates on the rise, a financial manager may look for ways to
protect the unrealized gains in his or herfirm'sfixed rate liability (and
hedge) portfolio, without compromising the firm's upside potential
should all-in rates rise even further. The manager might buy a
Swaption today, giving his or her company the right to receive fixed
at around current rates, a right to be executed once at the end ofthe
year. Pay, however, nothing today; instead, the manager uses his or
her future buyout gain to pay for the premium. If rates are lower in
a yearns time, he or she can execute the Swaption and defacto realize
the value ofthe hedge at today's high rates.
If rates are higher, he or she can let the Swaption expire unused
and execute a buyout at then prevailing higher rates. As a result, no
matter where rates are in a year's time, the manager will be able to
execute his or her buyout at a rate that is at least as high as it is today:
He or she has protected most ofthe current unrealized gain, and kept
the upside potential.
A rise in interest and Moreover, instead of paying "good" cash today to protect a future
a steepening in the gain, the manager has used a portion ofthe buyout value ofthe Swap
yield curve are creat- to pay the premium. Note, moreover, that (1) the manager will want
ing opportunities to to ensure that the option cc^t does not consume an unreasonable
percentage of his or her unreahzed gain, and (2) if he or she decides
unwind or assign to keep the swap in a year's time, the option premium could be
unwanted swaps at amortized into his or her existing swap coupon to avoid a cash
attractive gains, or payment on that date.
at least smaller
losses... Buyout of an Existing Low Coupon Swap
A rise in interest and a steepening in the yield curve are creating
opportunities to unwind or assign unwanted swaps at attractive
gains, or at least smaller losses: as term rates rise, the market value
of distantfixedrate coupons on existing debt and swaps will fiourish
extravagantly. Swaps, ofcourse, may be unwound in pieces small and
large (e.g., by averaging-in a first $25MM tranche out of a $50MM
swap position), or in pieces long and short (e.g. by selling the last 3

322 Journal of Corporate Accounting and Finance/Spring 1991

 Strategies for Interest Rate Risk Management

years of a 7 year swap, where the biggest gain resides because of the
steepening yield curve).
Suppose a swap had been acquired at 8.5 percent during kinder
days; now, in a 9.5 percent rate environment, the manager looks very
smug indeed The position he or she proudly holds is equivalent to
having bought a cap and sold a floor at 8.5 percent. A buyout (or
cancellation) of the existing swap at current rates of 9.5 percent would
net a gain of 100bps pa (9.5 percent-8.5 percent). Before contemplating
In both instances.. early retirement, the manager should consider selling a 9.5 percent
the firm, is left cap, ignoring floors all together, and keeping your existing swap on
the books. Because the manager would never buy afloorback in this
exposed to rates case, he or she ends up earning a full cap premium. Thus, he or she is
above 9,5 percent,. left with the following outcomes: The strategy out-performs a buyout
if rates rise past 9.5 percent-cap premixmi, (since the manager here
lags the market by lOObps+cap premium while the buyout case lags
the market by 100bps), and underperforms the buyout if rates drop
below9.5percent-cappremium(becauseabuyout converts the manager
to a floating rate-lOObps while this cap alternative keeps him or her
fixed at 8.5 percent less the premium earned). In both instances,
however, thefirmis left exposed to rates above 9.5 percent—a problem
that can be addressed independently.
Reversing a Swap
Let us assume that sometime ago, after examining the firm's
interest rate exposure, a manager entered into a swap to raise his or
her overall hedged ratio, payingfixedat 8 percent for 10 years. A year
later, rates have risen to 10 percent, a large enough move to warrant
a serious review of the firm's portfolio average hfe and to consider
reahzing some imbedded values. The financial manager decides to
take advantage of market volatility and to lock-in a portion of the
gains, shorten maturities somewhat, and raise, at the margin, the mix
of floating rate debt.
In the process, the manager chooses to realize the handsome 2
percent per annum (pa) gain in the existing 8 percent swap with a
remaining 9 year life.
Now rather than cancelling the 8 percent swap (with a 9-year
remaining hfe) and taking the profit upfix)nt,the manager cunningly
decides to lock in the gain by keeping the 8 percent swap outstanding
and receiving a current market rate of 10 percent in a new 9-year
swap, thereby securing the margin in the form of a 2 percent pa 9-year
annuity. As volatility eventually brings market rates back to, say, 8
percent, the 2 percent annuity can be realized by cancelling both
swaps and obtaining the present value of that stream. Thus, he has
achieved the present value receipt of a 2 percent pa annuity, realized
in a 10 percent environment, but discounted at the current 8 percent
market rate, resulting in a much higher PV amount than if the same
annuity had been present valued and delivered in the 10 percent
environment that prevailed when the "buyout" was engineered.
Raising his voice over the murmur of congratulations, he sagely notes

Journal of Corporate Accounting and Finance/Spring 1991

323
 Phillipe C. Burke

that executing this "buyout" requires having 2 swaps outstanding,

instead of none in the case of a standard cancellation: With two swaps
and two cancellations (instead ofone) comes an incremental Bid/Ofier
spread. But with the recent signing ofthe latest bankruptcy bill, swap
market participants are now able to manage the net instead of
aggregate exposure they have to any one coiinterparty, lowering their
capital requirements and resulting pass-through costs in the case of
offsetting swaps.
. . . with the recent
signing ofthe latest Monetizing a Deep In The Money Call
bankruptcy billy As option strategies proliferate, some of us have found it useful to
swap market partici' brush up on how to draw and use "payofi'diagrams"—those quiet little
pants are now able graphs depicting the profit and loss potential of different hedging
to manage the net strategies. Suppose a firm has a 5-year, 12 percent bond that is
instead of aggregate callable in 3 years at par, and is considering a Swaption to realize the
exposure they have value of that call today, while rates are still low. If rates are below 12
percent in 3 years, the bond is called and the Swaption is exercised,
to any one counter- putting the firm back at 12 percent. If rates are above 12 percent, the
party . . . call and Swaption expire useless, leaving thefirmagain at 12 percent.
The call is thus monetized, quite sensibly indeed. A payoff diagram
however may show that a Forward Swap in which the firm pays 12
percent (less any floating rate spread) from years 3 to 5 can actually
be more desirable (see Exhibit 4). Both the Swaption and Forward
Swap generate income upfi'ont, but because the 12 percent call is so
high (in the the money), very little time value will be realized in the
Swaption sale, keeping the two premiums very close. If rates are
below 12 percent in 3 years, the firm calls tbe bond and the Forward
Swap keeps it at 12 percent, as would have occurred with the
Swaption. If rates are above 12 percent, the call expires, but the
Forward Swap holds a gain in the firm's favor, unlike the Swaption.
A payofT diagram can show that premium/gain tradeoff in brilliant
technicolor. Note also that Forward Swaps benefit from more liquid
markets than Swaptions, allowing more risk management flexibility.

Yield Curve Slope Hedge

Remember when rates were low and the yield curve was still flat
on its face? As the term structure steepens from its 1989-90 lows, the
cost of yield curve sensitive hedges (e.g., caps, collars, forward swaps)
may rise considerably, even ifboth short and longrates drop. Consider
the following yield curve hedge: Afirmcould enter into two forward
Swaps to (1) receive 9.45 percentfixedon $50MMfirom1991 to 1993,
and (2) pay 9.59 percent fixed on $ 15.44MM from 1991 to 2000. Ifboth
short and long rates rise by say 20bps, the loss in (1) (on a larger
amount and shorter maturity) will be offoet by a gain in (2) (on a
smaller amount and longer maturity), and vice versa if rates drop in
tandem. In other words, should rates generally drop, this structure
will not jeopardize the firm's benefits. On the other hand, if the yield
curve steepens by 20bps (including B/0 spreads) in the next year, the
firm will be able to offoet the higher cost of its planned yield curve

324 Journal of Corporate Accounting and Finance/Spring 1991

 Strategies for Interest Rate Risk Management

Monetizing the Value of a Call Using a

Swaption vs. a Forward Swap

sensitive hedge (e.g.. Cap) by the roughly $1.3MM gain resulting fi:x>m
unwinding (1) and (2). Note also that because (1) and (2) both have
start dates one year hence, this structure will cause no cash outlay on
thefirm'spart during the year it is implementing its hedging program.
Out of the Money Floors
Positioning ahead of a bumpy ride down to lower short-term rates,
some companies are, quite sensibly, contemplating purchases of caps
for rate protection and floors to convert old coUeirs into gleaming new
caps. Another dazzling strategy for participating in a rate drop over
the next few months is the acquisition of an out ofthe moneyfloor.For
instance, in a 9 percent rate environment, the cost of a 5-yearfloorat
6 percent on 3MoLIBOR barely shows up on the radar screen: say, 12
bps or $120,000 on $100MM. If volatility rises to its recent historical
average within, say, 3 months' time and rates are unchanged, the
market will bid the instrument back at a 25 percent gain to the
. . . some companies company. And if interest rates drop by 25bps, in parallel motion, the
are, quite sensibly, return from such a sale rises to 50 percent. Meanwhile, the downside
contemplating pur- can never exceed the 12bp outlay at time zero. Of course, rates
chases of caps for probably won't move in parallel fashion. In the above scenario, the
rate protection and greatest return comes from the heightened value of the far-dated
floors to convert old options imbedded in thefirm's5-year floor, but the manager could just
collars into gleam,- as easily sell off any portion ofthe floor, selectively keeping the rest
ing new caps. for later use.

Buying the Spread

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

Journal of Corporate Accounting and Finance/Spring 1991

Phillipe C. Burke

several weeks). A truly chilling encounter, partly explained by a

deceleration in the growth ofbanldng asset (loans) and the authorities
increased reliance on T-Bills for refinancings. There are several ways
to capitalize on this phenomenon, and three are reviewed here. First
is the spread lock, a contract committing a company's hanker to
receive (and the oimpany to pay) afixedspread agreed upon today in
a swap on, say, $100MM, for 3 years, which wiU be entered into at any
time the firm so desires within the next 3 months. For a 3 month
commitment, the spread may rise some 4.5bps above that of a spot
transaction, say, to 56hps. Ifspreads return to their historical average
(mid 70bps)in the next few months, managers wiU have the opportunity
to enter into swaps with an imbedded gain ofroughly $380,000 (which
may he realized immediately). And with 3 year spreads in their lower
one percentile, the chances of down side losses are quite diminished
indeed.
Another way of isolating the spread opportunity alone is to pay
fixed in a 3 year swap beginning today, and to take a long position in
3 year Treasuries (in the cash or futures markets), thereby eliminating
interest rate risk.
Finally a less than perfect option position might he constructed hy
(1) buying a swaption giving the firm the right to pay the current two
year swap rate for 1.5 years starting in 6 months, and simultaneously
(2) selling a six month Einropean put on the 2 year Treasury. The
attractiveness of this trade is its low upfix)nt cost—^roughly 4bps. The
drawback, however, is that an option on a swap spread does not
exactly equal an option on a swap minus an option on a Treasury.

Protecting an Unrealized Gain Held by a Weak

Counterparty
A little house cleaning in the hedge portfolio shows that a
hypothetical company now (or soon) could hold a sizeable gain in a
swap with a bank that is rapidly approaching extinction. With large
packs ofits creditors busily erecting brilliantly engineered gallows on
. . . a hypothetical itsfix)ntlawn, the nearly eviscerated entity is gradually drooping into
company now (or that great dark void ofreceivership. After a sHght twinge ofqueasiness,
soon) could hold a the company begins to attack the problem with a gush of enthusiasm,
sizeable gain in a exploring at first two non-swap alternatives: (1) it sends out to other
relationship banks a request for quotes on a Letter of Credit to back
swap with a bank any gain in the swap, and (2) it asks its existing swap counterparty to
that is rapidly collateralize the loss in the swap in question. Both alternatives are
approaching likely to generate an eerie, almost haunting silence. There are,
extinction. fortunately, three other (swap-driven) ways of warding ofif this
troublesome credit evU. One is to simply terminate the agreement
with the current coiinterparty, receive the buyout gain fi-om that
counterparty, and re-estabHsh a new position with another, more
creditworthy, entity. Under the so-called "extingxiishment** tax
doctrine, a buyout payment is considered to not have arisenfix>ma
"sale or exchange" of property, and such payment would therefore
generate an (immediate) ordinary income tax impact.

326 Journal of Corporate Accounting and Finance/Spring 1991

 Strategies for Interest Rate Risk Management

A second choice, economically equivalent on a pre-tax basis, is for

the company to assign its rights and obligations under the current
swap to a third party and once again receive a buyout gain (this time
from the third party), and then re-establish a new position with a
creditworthy entity.
In this instance ofan assignment of an in-the-money swap position
to an unrelated third party, the buyout gain received by the company
¥^11 prohahly be viewed as a "sale or exchange" of property, and will
generate an (immediate) capital gain tax impact. Note, however, that
. . . the distinguish' if the company believes that the counterparty's profile is not entirely
ing characteristic of without blemish, so will most other sober third parties. Thus, finding
one willing to buy out the company*s position at 100 cents on the dollar
proactive interest may require a small amoimt of divine intervention. (However, in the
rate risk managers is opposite situation, that is if there is a loss in a swap with some
their willingness to counterparty with a dreadful disposition, the hedge could be in quite
actively manage the a bit of demand these days!)
unrealized gains and A third alternative is for the original counterparty to assign the
losses that a debt swap position with the company to a third (creditworthy) entity of the
portfolio will inevita- compan/s choice, who will henceforth face the company in the
bly generate, as in- existing swap out to maturity. In all hkelihood, the existing and the
terest rates change new counterparties' measure of the company's buyout gain will differ
and as time passes. by the market's bid/offer spread. As a result, the assignment will
usually result in the existing counterparty paying the lower measure
of the buyout gain to the new counterparty and the company bridging
the difference up to the higher measure with a payment to the new
counterparty. Bid/offers aside, such an assignment will probably
result in no tax consequence at all to the company.^

CONCLUSION
As illustrated in this article, the distinguishing characteristic of
proactive interest rate risk managers is their willingness to actively
manage the unrealized gains and losses that a debt portfolio will
inevitably generate, as interest rates change and as time passes. This
active, hands-on approach to hability management differsfromtrading
a balance sheet; running a speculative futures account would
undoubtedly be more effective for the latter purpose. Instead, as the
examples sought to show, a proactive debt manager will selectively
take advantage of opportunities offered by today's volatile rate
environment within certain constraints of rate exposure, outlook, and
risk tolerance.
NOTES

1. Though simplified for eajse of exposition, all of the caBes are based on actual
problems the author encountered during the last year. Funding considerations are
set aside; the focus is on managing interest rate risk.

2. See "The Historical Cost of Fixed Vs. Floating Rate Debt' by Jack Buchmiller and
Jeff Pearsall, (September 1988) Security Pacific Bank, New York.

3. A good article on these tax issues appeared in the Tax Law Review, Volume 43,
Number 3.

Journal of Corporate Accounting and Finance/Spring 1991