We begin our discussion and analysis of Union Carbide Corporation’s interest rate risk management by looking into the Treasurer’s Group proposal further. We list some questions and concerns we have for the Group concerning the proposal. Then, we detail our response to the team’s proposal. We include our thoughts on how the proposal aligns with current company goals/policies, but also highlight some lingering concerns we have. From here, we analyze the proposal’s objectives to determine if they make sense. We believe the objectives do make sense, but also provide some suggestions on expansion of the objectives.
The focus of the Treasurer Group in developing a debt portfolio was on duration. We felt this measure to be appropriate for determining the ideal composition of debt given the cyclical nature of UCC’s business. The company’s profits generally highly correlate with the state of the economy, particularly the market interest rate. As such, a portfolio of debt that focuses on the timing of debt instruments will most effectively hedge interest rate risk, lower their interest expenses, and become less vulnerable to interest rate volatility and be more adaptable to a economic shifts. The Treasurer Group gained an adequate understanding of this concept in their analysis and used the information to develop an ideal portfolio of debt.
The proposal has some positive and negative aspects that need to be evaluated before approval. The active approach over short-dated instrument can be a profitable strategy if management’s expectation of short-term interest rate is right. Such strategy would protect the value of the debt since it would not change as much as the longer-duration bond. Nevertheless, the strategy has some costs including transaction costs, and the cost of acquiring market information to make good prediction. The limited approach over long-dated instrument can be beneficial because it reduces the interest rate risk that longer term to maturity bond possess. Overall, we suggest to approve the proposed implementation program since the benefits outweigh the costs.
Some important accounting measurement and issues related to the proposal is how to account for the long-dated and short-dated instrument. In particular, we discuss about the accounting for interest rate swap. We decided that the swap will be classified as fair value hedge because you pay floating rate and receive fixed rate. Then we also discuss about how to account for increase in fair value of the swap as interest rate moves up and down.
The Treasurer’s Group presentation on its new plan for managing interest rate risk proved extremely interesting and thorough, but as with any presentation, we had some questions. First off, why did the group originally feel that the company needed a formal policy to guide its interest rate risk-management program? And why is this the ideal time to implement such a system? Additionally, how did the group determine the optimal amount of swaps to purchase and the optimal division between fixed and floating rate debt at 40% floating? Moreover, why does the group feel that a “benchmark” debt portfolio is optimal especially due to the lack of previous research/knowledge on an ideal benchmark for UCC? What makes this type of portfolio better than other options? Additionally, in the study the group performed, what were the results from the three out of nine years that were not more advantageous to UCC when measuring how the normalized portfolio would have performed? With respect to the objective of creating a performance measure for the group, why do you think this offers a better measurement of performance than the previous measure? Do you anticipate any changes to the dynamics of the group? With respect to the management of long-dated and short-dated instruments, how will this new management structure affect our cost structure, especially for the short-dated