USB Manufacturing Inc. carries a sizeable portfolio of long-term debt in its balance sheet. The company expects increased volatility in long term interest rates and is concerned about its equity exposure to interest rate risk. The company has decided to pursue an asset-liability management approach where its total equity value will be fully immunized against any unexpected changes in long term interest rates. The USB’s current balance sheet is given below.
Assets Liabilities
Total Firm Value $800,000 Class “A” Bonds $150,000
Yield: 12% Yield: 10%
Duration: 8 Duration: 3
Class “B” Bond 250,000
Yield: 8%
Duration: 6
Equity 400,000
Total 800,000 800,000
a) What is the impact of a 1% increase in the general level of interest rate on USB’s equity value? Show your calculation.
b) What specific asset/liability strategies should the firm undertake to fully immunize (perfect hedge) its equity value against changes in interest rates? Show your calculations.