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January 1985, 
Vol. 67, No. 1
Posted 1985-01-01

Cash Flow or Present Value: What's Lurking Behind That Hedge?

by Michael T. Belongia and G.J. Santoni

Michael T. Belongia and G. J. Santoni investigate the effectiveness of various strategies by which depository institutions might attempt to hedge interest rate risk. The authors note that a substantial share of the professional literature on this subject emphasizes the maintenance of a fixed nominal cash stream to secure a certain level of earnings. In contrast to this advice, it is noted that the classical definition of interest rate risk pertains to changes in the wealth of a firm’s owners. With these two contrasting views of interest rate risk and conflicting advice on hedging strategies, Belongia and Santoni compare the effectiveness of cash flow hedging to equity hedging. Using examples based on a simple portfolio of interest-sensitive financial assets and liabilities, Belongia and Santoni illustrate the existence of a fundamental relationship in hedging interest rate risk: If a hedge fixes a certain cash stream, the firm’s wealth will vary with changes in the interest rate; if equity is hedged, the amount or timing of cash flows will vary but the wealth of the firm’s owners will be insulated. On the basis of this fundamental principle, the authors conclude that cash flow hedges do not eliminate interest rate risk.