Question

While market-based hedging instruments can be used to offset or counter uncertainties in interest rates and exchange rates as they impact the income statement, balance sheet hedges require a different approach. Assume you are the CFO of Toyota trying to offset the balance sheet risks associated with Toyota’s $4.5 billion investment in Georgetown Kentucky. Please explain how this risk would be offset by a combination of a 15-year Euro Dollar Bond with equal repayments in the last five years and a floating rate 10 year syndicated Euro-Dollar bank loan combined with an interest rate swap. Assume a fifteen-year straight-line amortization of the new Georgetown facility.

Answer 1

Hedging is the strategy that is undertaken by the companies when they want to reduce the effect of a risk that they have taken. Most of the hedges have an impact on the income statement of the company. But a balance sheet hedge is an accounting technique that is used to reduce the risk that is due to currency fluctuations and fluctuations in the value of assets that are foreign and have to be converted in domestic currency.

In this case, Toyota has invested in Euro-Dollar bond. The benefit of such bonds is that they are time deposits that are denominated in US dollars. The bonds are in European banks so the regulations are comparatively different from Federal government. It provides higher margins than bonds which are located in US. So, this will act as a good hedge against the currency fluctuations.