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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, mortgagebacked
securities, and 30-year Treasury bonds. The liabilities of Kayman Savings are mostly shortterm
certificates of deposit. Kayman has also sold some short-term commercial paper of its own.
Stephen Kayman, the president of Kayman Savings, suddenly realizes that the institution is 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
instruments fall much more. Consequently, if interest rates should rise, the market value of the S&L‟s
assets will fall further than the market value of its liabilities. 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
institution will experience cash flow problems. The relatively low fixed-interest revenue 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
duration gap. The swap will grow in value as rates rise, offsetting the equity losses. Again, the size,
timing, and other terms of the interest rate swap can be tailored to meet the particular needs of
Kayman Savings.
How to Choose the Appropriate Hedge
We have now examined forwards, futures, call options, put options, and swaps. We have observed
how these instruments can be used to hedge in a wide variety of risky scenarios. How does one choose
which of these instruments to use in a particular situation? When is a future better than a forward?
When should an option be used instead of a future? Should interest rate exposure be hedged with bond
futures or with swaps? The following steps will provide some guidance.
The first task in implementing a hedge strategy is to identify the natural exposures that the firm
faces. Does the firm gain or lose when interest rates rise? Does it gain or lose as the dollar
appreciates? Is a falling wheat price good news or bad news for the company? What about oil prices
and stock prices? How about foreign stock and bond prices? Is the company exposed, and if so, which
direction causes a loss?
Clearly the answers to these questions vary from firm to firm. The bakers benefited from falling
wheat prices while the farmer suffered. Rising interest rates might hurt a firm that has variable-rate