Correlated interest rate risk and funding strategies for nonfinancial firms

Abstract

This paper considers appropriate funding strategies for nonfinancial firms when operating cash flows are correlated with interest rates. An example expression is provided for the optimal funding position when the firm has a two-period investment horizon. The conclusion is that matching will be the best strategy if the unbiased expectations hypothesis of the term structure holds and operating cash flows are uncorrelated with interest rates. Since the optimal funding position will be the minimum-risk one if the expectations hypothesis holds, the properties of the minimum-risk funding strategy are also investigated. The primary result is that maturity matching will not necessarily be the optimal funding strategy even when, on average, the cost of long- and short-term funds is the same. Finally, some empirical estimates of minimum risk funding positions for nonfinancial firms are provided using data from the Quarterly CompuStat files. The data indicate that changes in corporate operating earnings are, on average, significantly positively correlated with changes in short-term interest rates, but that there is substantial cross-sectional variation across companies in our sample.