In the September 2016 FOMC meeting, governors and voting presidents of the Federal Reserve System agreed not to increase the federal funds rate target, but somewhat let the markets know that there could be a rise in the near future. How do you think that financial managers will react to this news? Which instruments can they use to hedge against a change in interest rates?

The prices of the bonds experience a significant amount of decline when the rate of interest increases. The interest rate risk occurs when the prices of bonds decrease. Therefore in order to reduce or mitigate the interest rate risk, financial managers utilize hedging instruments to hedge interest rate risk. Below are some key hedging instruments which the financial manager can utilize for hedging interest rate risk:

·         Purchasing short term bonds is a good way to hedge the interest rate risk. Short term bonds allow the financial managers to mitigate the interest rate risk up to a lot of extents. Although these bonds are for a short time period, these bonds provide a significant amount of return (Sercu, 2009).

·         The approaches such as bond laddering can be utilized for mitigating the interest rate risk (Chandra, 2011). By utilizing this approach the financial manager can reduce interest rate risk effectively. The bonds get matured on different dates which allows the manager to hedge risk (Sercu, 2009).

·         Different types of bonds can be purchased by the financial managers which include corporate bonds and government bonds. Different bonds will help the manager to reduce interest rate risk up to a lot of extents. The fund such as interest rate hedge fund provides high average yield.

Therefore it can be said that the financial manager can purchase a variety of bonds for reducing the interest rate risk effectively. It is important for financial managers to focus on interest rate risk (Chandra, 2011).

1.      If the finance company you manage has a gap of +$5 million (rate-sensitive assets greater than rate-sensitive liabilities by $5 million), describe an interest-rate swap that would eliminate the company’s income gap.

Swap can be described as a derivative instrument. It is utilized by the financial managers for exchanging the financial security of any type with another. Usually, organizations perform these kinds of transactions so that they can achieve different types of benefits. If the object beneath swap is a debt instrument than such swap is called interest rate swap (Sercu, 2009). The financial stability of any bank is evaluated by performing income gap analysis. The income gap can be explained as the difference between rate-sensitive liabilities and rate-sensitive assets (Chandra, 2011).

If any organization has higher rate-sensitive assets than rate-sensitive liabilities than RSA can be swapped with fixed-rate assets. Here it can be seen that the bank has more than 5 million rate-sensitive assets as compared to rate-sensitive liabilities (Sercu, 2009). Therefore these rate-sensitive assets of the banks should be swapped with 5 million fixed-rate assets. By doing this income gap can be eliminated. An interest rate swap is utilized for eradicating the risk related to interest rate risk. It is highly essential for the financial managers to eliminate or to mitigate interest rate risk (Chandra, 2011).

References of International Finance

Chandra, P. (2011). Financial Management. Tata McGraw-Hill Education.

Sercu, P. (2009). International Finance: Theory into Practice. Princeton University Press.