1. Interest Rate Risk and Financing Choices Prof. Ian Giddy New York University Treasury 2000 NYU/GTA

2. Copyright ©1999 Ian H. Giddy Interest Risk Management -2 Financial Risk Management l Why does it matter? l Why and when should we hedge? l What should we hedge? How should we gauge exposure? l Financial risk management must be tied to the company’s business

3. Copyright ©1999 Ian H. Giddy Interest Risk Management -3 IBM’s Interest Rate Exposure

4. Copyright ©1999 Ian H. Giddy Interest Risk Management -4 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

5. Copyright ©1999 Ian H. Giddy Interest Risk Management -5 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

6. Copyright ©1999 Ian H. Giddy Interest Risk Management -6 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

7. Copyright ©1999 Ian H. Giddy Interest Risk Management -7 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT INVESTMENT FINANCING RISK MANAGEMENT

8. Copyright ©1999 Ian H. Giddy Interest Risk Management -8 Financing Choices Assets’ value is the present value of the cash flows from the real business of the firm Value of the firm =PV(Cash Flows) From How much debt? to What kind of debt? You cannot change the value of the real business just by shuffling paper - Modigliani-Miller

9. Copyright ©1999 Ian H. Giddy Interest Risk Management -9 Corporate Financing Choices: What Kind of Debt? l Fixed/floating l Currency of denomination l Maturity or availability l Domestic/Euro l Public/private l Asset-based l Credit enhanced l Swapped l Equity-linked

10. Ciba-Geigy: What Kind of Debt?

11. Copyright ©1999 Ian H. Giddy Interest Risk Management -11 Short Term or Long Term? l In 1992, Ciba had fixed assets of SF13.9 billion and capital expenditures of SF1.9 billion. l Yet the majority of Ciba's debt is in the short-term commercial paper, bank debt, and suppliers-credit markets. l This suggests that if the proportion of debt financing as a whole is increased, much of it should be in the form of long- term debt.

12. Copyright ©1999 Ian H. Giddy Interest Risk Management -12 l Geographic location of sales and capital assets. l Currency distribution of sales. l Nature of the company's businesses Currency of Denomination of Ciba's Debt? What Should It Be?

13. Copyright ©1999 Ian H. Giddy Interest Risk Management -13 Currency of Ciba’s Assets and Debt Geographic distribution of Currency distribution of sales Remarks on economic exposure Estimated currency distribution of debt Fixed assets Sales Switzerland41%  43% 2.4%Net short position because much of production, but little of sales, here 9% U.K.  27% 5.4%Part of sales effectively U.S. dollar denominated 7% Other Europe 34.6%21% U.S. and Canada 23%32%41.3%54% Latin America 4%7%5.3%Most of sales effectively dollar denominated 2% Asia4%13%10.9%Part of sales effectively U.S. dollar denominated 6% Rest of the world 1%5%Most of sales effectively dollar denominated 1% Geographic distribution of Currency distribution of sales Remarks on economic exposure Estimated currency distribution of debt Fixed assets Sales Switzerland41%  2.4%Net short position because much of production, but little of sales, here 9% U.K.  27% 5.4%Part of sales effectively U.S. dollar denominated 7% Other Europe 34.6%21% U.S. and Canada 23%32%41.3%54% Latin America 4%7%5.3%Most of sales effectively dollar denominated 2% Asia4%13%10.9%Part of sales effectively U.S. dollar denominated 6% Rest of the world 1%5%Most of sales effectively dollar denominated 1%

14. Copyright ©1999 Ian H. Giddy Interest Risk Management -14 What Kind of Debt? Some Considerations l Fixed/floating:  How certain are the cash flows? Are operating profits linked to interest rates or inflation? l Currency:  Consider currency of the assets: currency of denomination vs. currency of location vs. currency of determination. l Maturity or availability:  Are the assets short term or long term? Should the firm assume ease of refinancing, or buy an option on access to financing?

15. Copyright ©1999 Ian H. Giddy Interest Risk Management -15 Guidelines for Financing l Liabilities to match assets: economic exposure of the firm determines base financing choices. l Decision on whether or not to fully match depends on company's view relative to the view implied by market prices. l When strategy is chosen, use the financing/hedging techniques that offer the lowest effective cost.

16. Copyright ©1999 Ian H. Giddy Interest Risk Management -16 Designing Debt DurationCurrencyEffect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Straight versus Convertible - Convertible if cash flows low now but high exp. growth Special Features on Debt - Options to make cash flows on debt match cash flows on assets Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across different locales Consider ratings agency & analyst concerns Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing Consider Information Asymmetries Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt If agency problems are substantial, consider issuing convertible bonds Can securities be designed that can make these different entities happy? If tax advantages are large enough, you might override results of previous step Zero Coupons Operating Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed

17. Copyright ©1999 Ian H. Giddy Interest Risk Management -17 What is a Corporation’s Sensitivity to Interest Rate Changes? l The answer to this question is important because it  it provides a measure of the duration of the firm’s projects  it provides insight into whether the firm should be using fixed or floating rate debt.

18. Copyright ©1999 Ian H. Giddy Interest Risk Management -18 Interest Rate Risk: Portfolio l Portfolio risk: interest rate fluctuations can affect the value of a bond investment portfolio l Bond price fluctuations will affect the balance sheet l Can be hedged, using duration as a risk/sensitivity measurement tool l Can be hedged with futures, bond options, and swaps.

19. Copyright ©1999 Ian H. Giddy Interest Risk Management -19 Pepsico Pension Assets (each $10m):  2-year GNMA  6-year, 8% T-note  12-year asset- backed corporate Pension liabilities:  $100m 2 years  $120m 5 years  $85m 10 years l What is Pepsico pension fund’s risk?  Duration of the assets (+ve)  Duration of the liabilities (-ve)  Net duration is the risk to be hedged!

20. Copyright ©1999 Ian H. Giddy Interest Risk Management -20 The Price-Yield Relationship But plotting price vs yield shows that the relationship is non-linear: 100 9% Price of a 9% bond

21. Copyright ©1999 Ian H. Giddy Interest Risk Management -21 Duration as a Measure of Price Sensitivity Duration measures the % price change for a given change in yield: PRICE YIELD9% 100 The steeper the line, the more the price falls for a given rise in yield

22. Copyright ©1999 Ian H. Giddy Interest Risk Management -22 Greater Duration, Greater Risk Duration is measured as the PV-weighted average life, so low-coupon bonds have greater duration PRICE YIELD9% 100 6% BOND 9% BOND 0% BOND

23. Copyright ©1999 Ian H. Giddy Interest Risk Management -23 Calculating Duration: MacCauley and Modified

24. Copyright ©1999 Ian H. Giddy Interest Risk Management -24 Calculating Modified Duration: Shortcut Method The average percentage price change, relative to the initial price, per 1-basis-point change in yield:

25. Copyright ©1999 Ian H. Giddy Interest Risk Management -25 Duration: An Excel Spreadsheet

26. Copyright ©1999 Ian H. Giddy Interest Risk Management -26 Assets (each $10m):  1-year E$ deposit  5-year, 6% T-note Duration=4.6  9-year Strip Fixed liabilities:  $10m 3 years  $10m 5 years  $10m 7 years u Pension Fund’s risk? u Asset Duration = 10(1%)+10(4.6%)+10(9%) u Liab Duration = 10(3%)+10(5%)+10(7%) u Net duration is 1.46-1.50 = -4m Pension Fund, simplified

27. Copyright ©1999 Ian H. Giddy Interest Risk Management -27 Do Corporations Have Durations? : Firm Value Rates

28. Copyright ©1999 Ian H. Giddy Interest Risk Management -28 Firm Value versus Interest Rate Changes: Walt Disney l Regressing changes in firm value against changes in interest rates yields the following regression – Change in Firm Value = 0.22 - 7.43 ( Change in Interest Rates) l Conclusion: The duration (interest rate sensitivity) of Disney’s asset values is about 7.43 years. Consequently, its debt should have at least as long a duration.

29. Copyright ©1999 Ian H. Giddy Interest Risk Management -29 Why the coefficient on the regression is duration.. l The duration of a straight bond or loan issued by a company can be written in terms of the coupons (interest payments) on the bond (loan) and the face value of the bond to be –

30. Copyright ©1999 Ian H. Giddy Interest Risk Management -30 Duration of a Firm’s Assets l This measure of duration can be extended to any asset with expected cash flows on it. Thus, the duration of a project or asset can be estimated in terms of the pre-debt operating cash flows on that project.

31. Copyright ©1999 Ian H. Giddy Interest Risk Management -31 Duration of Disney Theme Park (Based on Cash Flow Projections)

32. Copyright ©1999 Ian H. Giddy Interest Risk Management -32 Duration: Comparing Approaches

33. Copyright ©1999 Ian H. Giddy Interest Risk Management -33 Interest Rate Risk: Economic u Economic risk arises from the real business risk of the company, insofar as it is tied to market interest rates u It affects the shareholder value, but may be difficult to quantify u It can often be hedged using forwards, futures or interest-rate swaps. u Example: Cincinnati Constr. Co. uses collar to hedge its interest cost; this is consistent with its business risk.

34. Copyright ©1999 Ian H. Giddy Interest Risk Management -34 Liberty Travel l Liberty is afraid of a higher cost of funds in the future. Should it:  Borrow at 8.85% for 3 years?  Fix the cost for the next quarter with an FRA (at 6.125%+1.85%)?  Fix the cost for 3 years with an interest rate swap at an effective cost of 8.82% (6.97%+1.85%=8.82%) ?  Use futures (at 6.07%+1.85%)?  Do nothing?

35. Copyright ©1999 Ian H. Giddy Interest Risk Management -35 Three Views of Interest Rate Risk Transactions Exposure Transactions Exposure Portfolio Exposure Portfolio Exposure Economic Exposure Economic Exposure

36. Copyright ©1999 Ian H. Giddy Interest Risk Management -36 Designing Debt DurationCurrencyEffect of Inflation Uncertainty about Future Growth Patterns Cyclicality & Other Effects Define Debt Characteristics Duration/ Maturity Currency Mix Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future Straight versus Convertible - Convertible if cash flows low now but high exp. growth Special Features on Debt - Options to make cash flows on debt match cash flows on assets Start with the Cash Flows on Assets/ Projects Overlay tax preferences Deductibility of cash flows for tax purposes Differences in tax rates across different locales Consider ratings agency & analyst concerns Analyst Concerns - Effect on EPS - Value relative to comparables Ratings Agency - Effect on Ratios - Ratios relative to comparables Regulatory Concerns - Measures used Factor in agency conflicts between stock and bond holders Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts Type of Assets financed - Tangible and liquid assets create less agency problems Existing Debt covenants - Restrictions on Financing Consider Information Asymmetries Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt If agency problems are substantial, consider issuing convertible bonds Can securities be designed that can make these different entities happy? If tax advantages are large enough, you might override results of previous step Zero Coupons Operating Leases MIPs Surplus Notes Convertibiles Puttable Bonds Rating Sensitive Notes LYONs Commodity Bonds Catastrophe Notes Design debt to have cash flows that match up to cash flows on the assets financed

38. n www.stern.nyu.edu

39. www.giddy.org

40. Copyright ©1999 Ian H. Giddy Interest Risk Management -40 Ian Giddy Ian H. Giddy NYU Stern School of Business 44 West 4th Street, New York, NY 10012 Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org