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The IUP Journal of Financial Risk Management
When a Hedge Turns into Speculation: Interest Rate Swaps at Canadian Universities
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The present paper intends to develop an analytical condition for an interest rate swap (variable rate for fixed rate) to be beneficial and examines the incidence and effectiveness of swaps in the Canadian university sector. The paper demonstrates the lack of any cost advantage in a two-party swap through a contradiction analysis and then tests whether there is evidence that the use of this derivative is indeed acting (or not) as an effective risk management tool. The paper also applies a nonparametric Kruskal-Wallis test to determine whether the size of the university is a factor in the effectiveness of swap. Of the 31 Canadian universities using swaps, only five pass the analytical condition to be judged as an effective swap. The balance fails the test, indicating that the usage of the swap, in essence, unhedges a natural hedge that the institution had. The results also indicate that university size plays a role in whether the hedge is effective or not. This paper is unique in applying a quantitative test to determine swap effectiveness in the Canadian university sector. It also points to the necessity for management of these institutions to better understand the effects and uses of derivative financing instruments for hedging purposes.

 
 
 

Interest rate swaps are a commonly used tool for risk management, particular to organizations exposed to interest rate risk. If a firm borrows on a variable interest rate, it is exposed to the risk of changing interest rates in the future. To mitigate this risk, the firm may enter into a swap contract, wherein it will pay fixed interest on a notional principal to the swap dealer and, in turn, receive variable interest cash flows from the dealer. This effectively limits the losses an organization may experience from upward changes in interest rates. When the variable interest declines, the firmís cash outflow of interest on the borrowing will be less and so will be the receipts from the swap dealer.1 When the variable interest goes up, the increased borrowing cost will be offset by the increased receipts from the swap dealer.

Though it is possible to manage the interest rate risk through other exchange traded derivatives like interest futures and options, an interest rate swap has the advantage of customization. The disadvantage is that unlike exchange traded futures or options, terminating a swap may not be a simple process and can be costly. According to the Bank of International Settlement statistics, interest rate swaps are the single largest segment in OTC derivatives markets. At the end of December 2016, they accounted for 57% of the notional amount of all outstanding OTC derivatives and 59% of the total gross market value.2

 
 
 

Financial Risk Management Journal,Cost Effectiveness Hypothesis, Hedge to Bet Cut-Off Point, Interest Rate Swaps at Canadian Universities.