Introduction to Fixed Income Securities

Assignment

Union Carbide Corporation: Interest Rate Risk Management

1Q. Examine the objective of the plan: stated objectives, unstated objectives and alternate objectives.

Stated objectives:

1. Design a “normalized liability portfolio” for Union Carbide Corporation (UCC), defined as the optimal structuring of the Corporation’s entire debt portfolio that will simultaneously assure the lowest financing cost to the company and minimize the exposure to adverse changes in interest rates.

2. Create a long-term financing and interest rate risk management performance measurement system based on the normalized portfolio which will simultaneously assure the lowest cost to the company and minimize the exposure to adverse changes in interest rates.

Unstated objectives

1. Developing a benchmark debt portfolio and define the optimal composition of its debt portfolio to evaluate any new financing opportunities.

2. Transforming at least a smexposure protects equity value against all portion of its extant fixed rate debt into a floating-rate liability so that it could lower its expenses in a downturn economy.

2Q. Discuss the appropriateness of the ultimate target in the proposed plan.

Appropriateness of the plan1. Maximizing the spread between return on capital and cost of capital would make it to obtain

the lowest financial cost.2. Greater the cash flow and greater the spread generated by the company would increase the

present value of the shareholders’ wealth and company’s assets.3. Minimizing the present value of the debt portfolio, in turn, would increase shareholders’

value. It will be achieved by minimizing the cost of capital and present value of debt. The cost of capital affects the value of assets, while the present value of debt portfolio affects the value of liabilities. However it should be balanced because when cost of capital falls, present value of the debt portfolio increases to maximize the net increase in shareholder value.

4. Opportunities to influence financial performance also exist through liabilities as the business is in competition to maximize operating performance.

5. The matching of asset and liability interest rate exposure protects equity value against interest volatility.

3Q. If the firm accepts the premise of the plan, as well as the measurement of the duration of UCC’s assets, how then should the firm implement the plan?

Implementation of plan1. UCC’s risk-management activities should be evaluated on a portfolio basis.2. Any evaluation of liability management must recognize opportunity cost as well as actual

cost.3. Any policy needed to address was the concept of active versus passive management of the

portfolio. So it is to establish a policy that would govern when it might be appropriate to adjust the actual portfolio so that it deviates from the normalized one.

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4. Any interest rate risk-management performance- measurement system should ascribe some value to having some base amount of committed term funding in place, regardless of the portfolio’s optimal makeup.

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