Mastering Interest Rate Risk Strategy

Part 4

HEDGING MAKES SENSE UNDER SPECIFIC CIRCUMSTANCES ONLY

6 Hedging theory

INTRODUCTION TO PART 4

The key learning outcome in Part 4 is that you will understand when hedging increases firm value – thus, when it will make sense and when it won’t. Part 4 is the third out of four stages in a firm’s interest rate risk management process.

Hedging does not make sense under all circumstances. If a firm hedges for the wrong reasons, hedging may even decrease instead of increase firm value because hedging costs money! As I have said, a necessary condition for a firm to create value with hedging is that it is exposed to interest rate risk. However, being exposed to interest rate risk alone is not sufficient. In this part I will explain to you ...