Libor Case

One of the common benchmark interest rate is London Inter-Bank Offered Rate, or LIBOR, which is the rate of interest at which banks borrow funds from each other in the London inter-bank market. It is quoted for maturities of one day to one year for 10 major currencies. As it is the rate paid by banks with highest credit quality, most firms will borrow at a rate that exceeds LIBOR (Berk & DeMarzo, 2007, p. 859). It means for firms the rate must be LIBOR plus premium because of lower credit quality.

When a firm has borrowing funds, it cannot avoid interest rate risk and of course, a firm does not want the interest rate uncertainty, management of the firm with a loan based on a floating rate index, such as LIBOR, is facing to the risk that short-term interest rates may rise, causing borrowing costs to rise. What the firm concern is whether interest rates rise fast and far enough to have a significant impact on firm's budgeted interest expense.

LIBOR is floating and is not fixed from time to time but it has fixed spread. One of important strategies in managing interest rate risk is diversification. It appears that a firm that hedges its floating rate debt financing will experience lower cost of borrowing than unhedged firms if interest rates become higher.

Firms often use a diversification strategy which is creating a mix of fixed and floating rate debt. A firm borrows at the short term of the yield curve with floating rate loan to get lower interest rates. A firm is protected against future increases in short-term interest rates with fixed rate loan. A mix of two kinds of rate loan leads to the situation that a firm can operate to get an outcome that is better than the worst case scenario (if it happens). In fact, most firms are not be able to get fixed interest rate from their banks.

The two most popular derivative tools used to hedge floating rate debt are interest rate swaps and caps. As these instruments are typically traded