Financial Accounting: In an Economic Context

INTEREST RATE SWAPS AND HEDGING

Almost all major companies rely on long-term debt financing (e.g., bond issuances) where the issuing company makes fixed interest rate payments to debtholders over the life of the debt contract. As illustrated in this chapter, entering into fixed-interest-rate contracts exposes the issuing company to market rate risks—when market interest rates rise, the market value of the liability falls and the company experiences an economic gain; as market interest rates fall, the value of the liability rises and the company experiences an economic loss. Effective risk management attempts to reduce these risks as much as possible because investors avoid risky investments. Creditors impose stricter credit terms (e.g., higher interest rates, stricter debt covenants), and equity investors are willing to pay lower prices when they judge that a company's risk level rises.

A common method used by companies to reduce such risks is called hedging, where a company enters into a contract that creates risks that counteract or balance the risks attempted to be hedged (reduced). The most common method of hedging market interest rate risk is called an interest rate swap.

To illustrate how an interest rate swap can be used to hedge risks, assume that Peirson Company issues for face value ($1,000) a bond with a five-year maturity and a stated interest rate of 5 percent. This contract obligates Peirson to pay the bondholders $25 ([$1,000 × .05]/2) every six months for five years. ...