I would like to advise a new client on using interest rate derivatives to hedge against interest rate movements. The client is hoping to increase production capacity by 50% in the next two to three years due to increasing demand for its products. The client will need to obtain finance to fund the expansion. The yield curve is currently upward sloping; however, the client is worried that possible Federal Reserve actions to reduce inflation may result in a downturn in the economy.

As the client already has floating interest-based debt, it is enquiring about hedging potential interest rate risk using swaps.

 

a) In what ways could the client use swaps to reduce exposure to interest rate movements on its cost of debt?   Include an explanation of any disadvantages of using a hedge versus no hedge at all. 

 

b) In what ways could the client use an interest rate cap to reduce exposure to interest rate movements on its cost of debt? Include an explanation of any disadvantages of using the cap vs. no hedge at all.