With the help of the current value of the possible future cash flows, the market values for interest and foreign currency exchange risk are found out. However, the information according to the sensitivity analysis will not necessarily signify the real changes in fair value that IBM would face in case of normal market conditions as, due to practical confinements, all variables except for the particular market risk factor are held constant.
Coca Cola Company makes the use of derivative financial instruments mostly to lessen their exposure to unfavorable fluctuations in the foreign currency exchange rates and in interest rates and commodity prices involved as market risks. The company does not go into derivative financial instruments in order to carry out trading.
In fact, risk by hedging and primary economic exposure is reduced by all their derivative positions. Owing to the high connection between the underlying exposure and hedging instrument, reciprocal changes in the value of the underlying exposure is used to counterbalance fluctuations in the value of the instruments. Practically all of Coca Cola's derivatives are simple, over-the-counter instruments with liquid markets.
If the firm has borrowed on a floating rate basis, at very reset date, the rate for the following period would be set in line with the market rate. The firm's future interest payments are therefore uncertain. An increase in rates will adversely affect the cash flows.
Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal.
On the other hand, consider a firm, which has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently inflation rate in the economy slows down and the market rate of interest declines. The cash flows from the project may decline as a result of the fall in the rate of inflation but the firm is logged into high cost borrowing.
As compared to an increase of $18 million on December 31, 2005, there would be reduction in the fair market value of IBM's financial instruments of $113 million, which would be a result of a 10% reduction in the levels of interest rates on December 31, 2006, keeping all other variables constant. On the other hand, as compared to a reduction of $8 million at December 31, 2005, there would be a hike in the fair value of IBM's financial instruments of $96 million, which would be a result of a 10% increase in the levels of interest rates, keeping all other variables constant. Alterations in IBM's interest rate profile and amount and debt maturities have