Question

In the July 2017 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?

Answer 1

An increase in the interest rate means that the price of bonds will decline in order to make them attractive for the investors. So, an increase in the interest rate means that existing bond holders will find that the value of their initial investment has declined. So, a financial manager needs to provide a hedge against this interest rate risk to the investors.

instruments that can be used:

1. Moving to short-term bonds: Short-term bond due to their very nature provides higher returns as compared to other financial market instruments. So, it is advisable that investors move some part of their investment in short-term bonds.
2. Interest rate hedge funds: Such funds hold a combination of variety of bonds including, government bonds, and high yield bonds. Such funds reduce the interest rate risk by keeping a portfolio of securities having different maturity dates (short-term to long-term). In this way average yield of the fund is kept high while providing hedge against high interest rates.
3. Variable rate instrument: These financial instruments does not offer fixed rate of return, instead they offer interest rate that varies overtime. So, when interest rates are rising, such instruments by providing higher yields gives protection against rising interest rate risk.