Hedging with Interest Rate Derivatives Recall that if the economy continues to b

Question

Hedging with Interest Rate Derivatives

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. Carson currently relies mostly on commercial loans with floating interest rates for its debt financing. It has contacted Blazo Bank about the use of interest rate derivatives to hedge the risk.

a. How could Carson use interest rate swaps to reduce the exposure of its cost of debt to interest rate movements?

b. What is a possible disadvantage of Carson using the interest rate swap hedge as opposed to no hedge?

c. How could Carson use an interest rate cap to reduce the exposure of its cost of debt to interest rate movements?

d. What is a possible disadvantage of Carson using the interest cap hedge as opposed to no hedge? Explain the trade-off between using an interest rate swap versus an interest rate cap.

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Hedging with Interest Rate Derivatives Recall that if the economy continues to b

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