Importance of Interest rates derivatives as a Risk Management Tool

Importance of Interest rates derivatives as a Risk Management Tool
April 13, 2011 Comments Off on Importance of Interest rates derivatives as a Risk Management Tool Academic Papers on Business Studies,Sample Academic Papers admin

Sample Essay

Smith & Stulz reported that usually, companies use interest rates derivatives in order to reduce their financial distress and increase their market value[1]. Haugen & Senbet also proposed similar arguments in their research paper[2]. Adedeji and Baker deduce that if companies use derivatives only to mitigate their financial distress, there must be some relationship between the use of interest rate financial instruments and the indicators of risks which are operating and financial leverage[3].

Financial leverage means that the total amount of debt used in the capital structure of the firms and the Operating leverage means the amount of fixed cost used in the production process of the corporation[4]. Both of these factors are the true indicators of financial distress of the firms[5]. If the value of these two indicators is very high it means that company is highly leveraged and its risk of bankruptcy has increased. Hence, there is the possibility that companies will hedge their interest rate risk by using some interest rate derivatives. Grant and Marshall, however, argued that the main reason for using the financial derivatives by UK firms is the financial distress[6]. In their own words,

‘The vast majority of UK companies use derivatives to manage the traditional financial price risks of foreign exchange and interest rate risk. Relatively few respondents use either equity derivatives to manage the risks arising from their capital structure, or commodity derivatives to manage their commercial exposures’[7].

Grant and marshal did not mention that what type of derivative companies use to diminish the foreign exchange and interest rate risk[8]. Their research remains silent on the impact of financial distress on the use of interest rates derivatives. These gaps are covered in the study of Adedeji and Baker[9]. Another important objective of their research was to figure out the factors that influence firms to choose interest rates derivatives and currency derivatives. In the earlier studies, Geczy & Schrand found that companies use the financial instruments because they are heavily dependent on the products exported or imported from the foreign markets[10]. Another important variable is the international capital market which significantly impacts the firm’s decisions to go for these financial instruments. Alkeback & Hagelin found the risk of financial distress is negatively related to the interest rate derivatives[11]. They also found that the volume of financial leverage is positively related to the interest rates derivatives. It means that it is the financial distress rather than some speculative motives which force organizations to use financial instruments. Another important aspect of their study was that the managers of firms are more risk averse.

[1] Smith, C. W., and R. M. Stulz. “The determinants of firms’ hedging policies.” Journal of Financial and Quantitative Analysis, 1985: 391-405.

[2] Haugen, R. A., and L. W. Senbet. “The insignificance of bankruptcy costs to the theory of optimal capital structure.” Journal of Finance, 1978: 383-393.

[3] Adedeji, Abimbola, and C. Richard Baker. “Why Firms in the UK Use Interest Rate Derivatives.” Managerial Finance, 2002.

[4] Besley, Scott, and Eugene Brigham. Essentials of Managerial Finance,  loc. Cit.

[5] ibid

[6] Grant, K., and A.P. Marshall. “Large UK companies and derivatives.” European Financial Management, 1997: 191-208.

[7] Grant, K., and A. P. Marshall (p.195)

[8] ibid

[9] Adedeji, Abimbola, and C. Richard Baker loc. cIt.

[10] Geczy, C., and B. Minton & C. Schrand. “Why firms use currency derivative.” Journal of Finance, 1997: 1323-1354.

[11] Alkeback, P., and N. Hagelin. “Derivatives usage by nonfinancial firms in Sweden with an international comparison.” Journal of International Financial Management and Accounting, 1999: 105-20.

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