Finance

Finance Essay Capital Market Practice
Explain in detail how an Interest Rate Cap could be used to manage the interest rate reset risk for the issuer of the FRN

Interest Rate Caps safeguard against the risks of rising interest rates. It is just one of the techniques of managing interest rates, used mainly when the customer follows a variable lending rate system. Perhaps one of the main functions of interest rate caps is to afford protection against the rise in base interest rates, but it does not offer any kind of safeguards against fluctuations of acceptance fees or margins. The only area where interest rate caps can be useful is when it becomes intrinsic to counter interest rate vicissitudes. Again, .. .interest rate movements might result in little or no need for cap protection in which case the premium cost will exceed the compensation benefit you receive over the life of the Cap.Taxation (Phelan  Beattie, n.d., p.7). There are several aspects that impact the interest rate cap and its usage as an interest rate management tool. The first factor is the Strike Rate, or the maximum interest rate that can be enforced. In this case study, this is 6.25. Another aspect is the notional amount on which calculations are made. In this case, it is 250,000,000. Another feature is Reference Rate, or base rate that is to be provided at the start of the transaction.

In case an investor wishes to take advantage of this interest rate caps, he will need to make a non-refundable premium towards gaining befit of the cap.

Salient Advantages of Interest Rate Cap
In the event that the Reference Rate is greater than the Strike Rate, the difference in rate will be reimbursed to the investor.

The Strike Rate is a flexible one, and can be adjusted to suit the degree of protection the investor wishes to gain. However, the non-refundable premium payment will again fluctuate according to the strike rate.
Again, the term of the cap is flexible and may not have any bearing on the underlying facility. During wide vicissitudes in interest rates, it is possible to use interest rates caps as protection against such fluctuations.

Caps are revocable and since these are not linked to any underlying facility, these can be used for a variety of purposes.

The only costs that caps incur are non refundable premiums

Main Disadvantages

1. These are useful only in cases of increases in interest rate and becomes insignificant during times when interest rates fall.

2. Premium is non refundable and will need to be paid even if the reference rate does not fall below strike rate.
Taking the example of calculation of interest cap
Strike rate  6.25
Reference rate  7.25 ( assumed)
Notional amount- 250,000,000
6 months LIBOR
(Notional Amount) x (Reference Rate  Strike Rate) x ( of days in period360)
Or 250,000,000 x 1.00  x 180360  12,50,000

Thus this sum will be reimbursed to investor, in the event reference rate is more than the strike rate. However, this figure would vary with differences between reference rate and strike rate, and will not be gained in the event that the reference rate is lower than the strike rate.

Explain in detail how to use interest rate swaps to hedge the reset risk in the FRNLower credit rated firms need to pay high premium in order to participate in bonds. Interest rate swaps are intended to reduce such premiums and interests and thus bringing down overall costs. The main idea is borrowing initially on short term floating rates and then swapping the same for fixed interest rates. This is of special significance during times of rising interest rates, when loanees will be obliged to pay higher interest rates on their current loans and then if they possibly will have to pay under a fixed interest regime. This may create a mismatch between availability of income from assets and payment of liabilities. The idea is that the incomes generated from the assets stream should be more than the payment due to be paid on the liabilities. This is the underlying principle behind interest swaps. The aspect of the use of interest rate swaps to hedge reset risk can be further explained by way of an illustration. Let us assume two entirely different corporate enterprises, Ms ABC Irons Limited, and Ms Ever Alert Banking Corpn LLC. ABC happens to be a non-financial low credit rating company who needs to rely on fixed interest rate loans for their long term investment projects. But considering the fact that their financial credit rating is not very impressive, they will need to pay high premiums to gain such kind of funds. Conversely, Ever Alert Bank can easily draw forth funds through floating rates at lower interests because they enjoy a better credit rating.

The financial portfolios of these two entities are as follows
Serial ABC Irons LimitedEver Alert Banking Corpn.1.Could borrow  14 fixed interest in market Could borrow  12 variable rates in market 2.LIBOR  1LIBOR 0.5 3.Low credit rating  Very high credit rating
Thus the main factor that emerges from this comparison is that ABC Limited presently will have to pay 2 more than Ever Alert Bank.  In case ABCIL borrows using LIBOR, they become obliged to pay a premium of 1 loan amount where as the bank needs to pay only 0.5.

Both these entities would like to get into a swap transaction to lower interest burden and gain competitive and strategic advantages. As part of the swap arrangement, ABC Irons obtains floating rate bank loan on which it will initially pay LIBOR  1. Simultaneously, the bank will issue 12 fixed Seven-Year Bonds at LIBOR  0.1. As a result of this swap, the following scenario emerges

The bank takes over the loan of ABC Irons along with the LIBOR. The balance 1 is to be paid by the latter.
 ABC takes over the bonds at 12 fixed interest rate and intermediatory fees of 0.1, in addition to 1 interest that is has to pay.

The benefits that would accrue to both ABC Irons and Ever alert bank are as follows

Benefits to ABC
They are able to get a fixed rate loan thus creating less cash flow problems for themselves
Their total commitment results in cost savings of 0.9 percentage points in that they need not have to pay 14 interest now.14  ( 12  1.0  0.1)

In the event of the swap, the bank would save the extra 0.5 LIBOR charge which they otherwise would have to bear.

The benefits that accrue from interest swaps are quite substantial in FRN. But what needs to be kept in mind is that these provide advantage when the interests rates are increasing. During times of constant falling rates of interests, they may serve little purpose, except perhaps in terms of exercising choice between fixed or floating rates. During regimes of interest rates, floating rates would be more beneficial, since the promoters would not need to be saddled with fixed interest rates, especially when such rates are higher than floating ones. 

3. Explain in detail how you would calculate the price of a three-year swap that will hedge reset risk for your company. You should illustrate your explanation with an appropriate numerical example

The value of the price of a three year swap could be ascertained by calculating the PVs of each of the cash flows generated through the use of discount factors

In the above case, therefore, the values could be derived as follows
Serial PeriodDaysRate (Libor  40 points)Notional
CF1. 1.1  30.6.091805.4250,000,000         6,875,0002.1.7  31.12.091805.9250,000,000         7,375,0003.1.1  30.6.101806.1250,000,000         7,625,0004.1.7  31.12.101806.4250,000,000         8,000,0005.1.1. 2011  30.6.111806.5250,000,000         8,125,0006.1.7- 31.12.111806.65 250,000,0008,312,500
The discounted cash flows of the above are
Cash Flows ()Discounted cash flows Amounts ()6,875,0005,871,5247,375,0006,390,3127,625,0006,773,4378,000,0007,289,1618,125,0007,629,1078,312,5008,049,172Total  42,002,713

Q 4 Explain the difference between Hedging and Insurance, and how using a futures contract or an option will enable you to manage the equity market risk in the pension fund portfolio

A hedge is an investment made to condense the unfavorable cost incurred in a security by equalizing the security related aspects or a technique to eliminate the financial risk. The hedging process is the process of nullifying the financial risk caused by the price fluctuation. It is depended on the factors like the sale and the purchase of commodities in the market. It is a frequent term in the securities and the foreign exchange markets. In commerce the hedging method is the one by which the traders counterbalance the strategies of investments by price fluctuations, it involves the buying and selling the goods at the time of the contract and buying or selling the things at the later stage. Despite the contracts the only aim of them is to discard the unwanted risk by the different agents like the forward contracts, swap, options, insurance policies and the derivatives. There are different categories of hedgeable risk, which have the value of the accounting amount which can be unfavorable to the value of the import market. The different risk associated are the interest rate risk, equity, volatility and lending of securities.

The insurance is a guaranteed reimbursement of certain probable future losses as a token of exchange for the investment on a periodic basis. Insurance is planned in such a manner as to shield the financial assets of the individual or the company in the catastrophic loss.

According to law and economics it is a kind of risk management basically used as a hedge against the unexpected loss. It is a kind of the exchange of the finance for a secured premium. There are many misconcepts of insurance, some consider insurance as a type gambling over a period of time. The future contract and the option are rapidly emerging gadgets for the pension funds they are also the strategic tool for the risk management.The quick growth of them is due to the vast outcome for the portfolio management. Options hold quite a lot of significant attractions for pension-fund portfolios. Once the initial policy and procedural hurdles is defeated, they give faster and inexpensive ways to implement strategies. The market risks are those risks that the markets fail in obtaining the expected results. The pensions are the long term of investment and the occupying some kind of asset allocation method to expand their assets.

Market risk is built-in to the assets themselves in fact, it is implicit that all asset classes will diverge from performance prospect over time. Pension systems can alleviate market risk by factoring probable correlation to portfolio diversification. The futures and option can affect the risk associated with the portfolio in terms of price variations in underlying security, price of the future contracts etc. These are used to hedge positions in the pension equity portfolios. There are different criteria when pension funds invest in the options, they are the tactic view, dynamic strategies, loss limitation and the profit limitations (Equity option for pension fund, 2007, para.3). The option term is quite an insubstantial issue a strategy of short-dated options, are insufficient as it has too much considerations against equity risk. But when options are too long the liquidity (price) becomes an issue. To carry out the appropriate evaluation, implied volatilities and correlations between indices are to be incorporated in spite of the market variables which are complicated to obtain. As the market risk for foreign equity portfolio investments is hedged, this should be included in the options value by means of a quanto adjustment. Performance shows that pension funds tend to lack the required trading and financial engineering expertise and experience. The keen focus on the pension portfolio industry will broaden the interest rate risk and inflation risk to equity exposure, the equity premium are responsible for the low interest rates and the viability of the pension premium.

5) Using the data given above, explain and demonstrate how you would calculate arbitrage free price of a six-month futures contract on the FTSE 100 index

Arbitrage refers to the financial transaction which helps in gaining instant profit without any involvement of risk factor. It is the process of purchasing commodity in one market for the purpose of selling it immediately to the other market. The frequent use of the term has increased its popularity and has expanded its meaning to, the process whereby underpriced securities are purchased and are sold at higher price, with the objective to earn more profit. The opportunity for the arbitrage exists when there is change in the future price from its fair value. Fair value is derived by adding spot price plus holding cost. A future contract is a contract, whereby the commodities and securities which posses standard quality are bought and sold on a particular date in a market place and for particular price.

Thus, in simple terms, arbitrage essentially means buying and selling simultaneously the same commodity or security in two different markets at two different prices, and pocketing a risk free return. A simple example of a arbitrage would be in the event of Wal-Mart selling CDs for 5piece, and in the other places such CDs being sold for 25piece.

An enterprising person could buy CDs from Wal-Mart at such low prices, sell the same at higher prices and pocket the difference. This is a typical example of a arbitrage profits.

However, arbitrage contracts could be of different characteristics and genres from sports activities, forward contracts, etc., wherever, the aspect of transacting or buying in one place and  rendering sales at another place, perhaps at different prices.