MATURITY HEDGING: In many ways, the decision on the mix of short-term and long-term finance to be employed is analogous to the choice between floating and fixed rate financing. For, the optimal mix will depend upon whether the economy is travelling up, or down, the business cycle. If it is up, opt for larger doses of long-term financing to stretch out the benefits of the lower rates. Otherwise, in a period of tight liquidity, CFOs can keep rolling over short-term obligations to save interest costs.

But the lure of lower interest rates should not lead to asset-liability mismatch problems. Warns the RPG Group's Hari Mundra: "Asset-liability mismatches can trigger severe financial distress, especially when long-term assets are funded by short-term liabilities." Indeed, the objective must be to match the maturity of the liability with that of the asset to be funded. Unless the CFO is certain about how interest rates will behave over the life of the asset, it makes sense to stick to this basic formula, especially when financing capital-intensive projects.

The Synthetic Hedges

FORWARD RATE AGREEMENTS. One of the simplest tools available to manage interest rate risks is the forward rate agreement (FRA). Just as a currency forward contract specifies an exchange rate for a future transaction, a forward rate agreement locks you to a particular interest rate. Normally, interest rates are determined at the time of the loan negotiation, but FRAs enable the corporate to settle on the rates in advance.

FRAs are already available for LIBOR-linked external borrowings, and rupee-based FRAs should debut shortly. Says P.H. Ravikumar, 44, executive vice-president, ICICI Banking Corporation: "With the emergence of a rupee yield curve, it is only a matter of time before the banks start offering two-way quotes on PLR-linked FRAs."

INTEREST RATE OPTIONS. FRAs, however, do not enable the corporate to benefit from favourable interest rate movements, creating opportunity costs. For CFOs uncertain about the future direction of interest rates, interest rate options are the best bet. They provide insurance, without limiting the upside potential. And embedded put and call options add flexibility to fixed rate debt offerings.

A call option would allow the issuer to buy back the bond at a pre-determined rate, thus enabling refinancing at lower rates in case they drop. The cost of such an option: higher coupon rates. Or, to avoid such an increase in coupon rates, the issuer can simultaneously offer investors a put option that gives the right to redeem the bonds early at a specified rate. But the mass exercise of put options in an environment of rising interest rates could cause the CFO's financing costs to, suddenly, surge.

To limit the risk associated with floating rate borrowings, the CFO can buy an interest rate cap. A cap option ensures that the interest rate paid by the corporate will always be lower than the prevailing benchmark rate and the cap rate. If the benchmark rate pierces the ceiling specified, the buyer of the cap will be compensated for the difference. If the rate remains below the cap rate, the corporate will not exercise the option. The cost of the hedge: the up-front premium paid for the cap.

An interest rate floor will operate in exactly the opposite fashion. A floor option would ensure that the rate charged is always the greater of the prevailing benchmark rate and the floor rate. Obviously, borrowers would opt for an interest rate floor only if it reduces the cost of risk management.

Selling an interest rate floor to the writer of the cap will trim the size of the upfront cap premium. The combination of a long position in a cap and a short position in a floor creates the aptly-named interest rate collar. Since the maximum and minimum rates are specified, both the losses and the gains are limited. In fact, the collar can be worked out in such a manner that the price of the cap equals the price of the floor, and the net cost to the borrower is zero. For example, the HDFC Bank devised precisely this combination for the Rs 471-crore Flex Industries to manage the interest rate risks arising out of the latter's $12-million three-year floating rate loan. Observes Luis Miranda, 36, senior vice-president (foreign exchange and derivatives), HDFC Bank: "With such interest rate options, corporate treasurers can now effectively manage the short- and medium-term risks they have on their books."

INTEREST RATE SWAPS. Interest rate risks can be shifted by converting a floating rate liability to a fixed rate liability, or vice-versa, through an interest rate swap. In a plain vanilla interest rate swap, a company that has borrowed at a floating rate enters into an agreement with a counter-party to make fixed-rate payments. The counter-party, which had borrowed on a fixed rate basis, can now make floating-rate payments. There is no exchange of principal; only the interest payments are swapped on a regular basis.

Often, an interest rate swap can be combined with a currency swap, which results in the exchange of floating rates payments in one currency for fixed rate payments in another currency. To hedge both its interest rate and currency exposures from ECBs, a corporate can swap its floating dollar exposures for a fixed rupee exposures. Hopefully, at the end of this rather circuitous exercise, CFOs will still be able to save on interest costs. Otherwise, it would have been simpler, and cheaper, to directly access the domestic markets.

More sophisticated variants of the basic swap deal can also be devised. In a deferred, or forward, swap, both parties agree to exchange their cash-flows at a future date. But even with a deferred swap, CFOs cannot benefit from favourable interest rate movements. A swaption takes care of this deficiency by making the swap contract optional. Again, the price of the lower opportunity cost is the up-front premium payable.

Hedging has its costs. CFOs that blindly equate risk management with risk avoidance will only end up subtracting from the very bottomline they seek to insulate through steep upfront premiums and opportunity costs. On the other hand, risk management does not necessarily mean taking positions in a host of derivative deals. For, as international experience has demonstrated all too graphically, derivative deals can collapse spectacularly, consuming entire companies in their wake. There is a very fine line between proactive risk management and speculation. And in the volatile financial markets of the 21st Century, CFOs must tread that difference carefully.