FINANCE

Finance

Finance and Investment: Capital Markets Practice

Introduction

Capital markets are parts of financial market where investors purchase and sell debt either long or short term and equity backed securities. While investing in capital markets there are various financial risks that investors have to face. These risks can mitigate through using different techniques such derivatives. In this assignment, a scenario is given in which Board of Directors have asked for the solution of the two concerns that they encompass concerning the financial market. These concerns are related to interest rate risk and equity investment.

Discussion

Answer 1: Interest Rate Cap

Interest rate cap is very useful in the cases like the given scenarios. It protects investors against rise in rate of interest whereas yet permitting investors to take benefits of reducing rate of interest. This is achieved through setting up the interest rate cap. Interest rate cap is a part of derivative where purchasers obtain payment at end of period and rate of interest surpass the decided strict price. For instance, cap will be a contract for receiving a payment for each month when LIBOR rate surpasses 2.5% (Hull, 2003, p. 74).

Caps are very beneficial when interest rates are fluctuating, i.e. investors can secure themselves through using this technique. For instances, a borrower on a loan has been paying LIBOR rate could save themselves against increase in interest rate through purchasing the cap at rate of 2.5%. If this interest rate surpasses 2.5% over a given period, therefore, payment that will be obtained from the derivative could be utilized to assist in making interest payment for that particular period. Thus, payments for interest from the view of borrower are efficiently capped at 2.5%. It essentially assures investors against the greater cost of borrowing than the level capped. Interest rate going over this rate, then investors would be paid compensation. This protection offers investors benefits from lower rate of interest if they arrive.

Interest rate cap as we know are usually used by borrower to hedge against floating interest rate risk. The formula that is used to determine the Interest Rate Cap is as followed:

(Current rate in Market - Rate of interest Cap) x principal x (number of days to maturity/360)

As company has issued £250,000,000 of Floating Rate Notes (FRNs) paying LIBOR plus 40 basis points, FRN has five years to maturity and pays semi-annual coupons and coupon is payable today, the next coupon has been set and is payable in 6 month time.

The below chart indicate the impact of 6% for 5 years

Input data

 

Annualized Cost of Cap

Notional principal, $

$250,000,000

Quarterly premium for cap

0.0469%

Maturity, years

5

Annualized premium rate, %/yr

0.0938%

Payments per year

2

Cap rate, %/yr

 

2.5000%

Fixed borrowing rate, %/yr

6.00%

Total cost, %/yr

 

2.5938%

Cap strike rate, %/yr

2.50%

 

 

 

 

Premium, basis points

40

 

 

 

 

 

 

 

 

 

 

 

 

Profile of an Interest Rate Cap

 

LIBOR interest rate on reset date, pct/year

 

5.50%

6.00%

6.250%

5.750%

5.85%

6.00%

Uncovered interest rate payment, pct/year

5.50%

6.00%

6.25%

5.750%

5.85%

6.00%

Calculation of capped interest rate payment

 

Normal quarterly interest payment

$6,875,000

$7,500,000

$7,812,500

$7,187,500

$7,312,500

$7,500,000

Receive cap cash flow

$3,750,000

$4,375,000

$4,687,500

$4,062,500

$4,187,500

$4,375,000

Cap premium payment outflow, $

$117,231

$117,231

$117,231

$117,231

$117,231

$117,231

Net quarterly cash outflow (All-in-Cost)

$3,242,231

$3,242,231

$3,242,231

$3,242,231

$3,242,231

$3,242,231

Capped interest rate payment, pct/year

2.594%

2.594%

2.594%

2.594%

2.594%

2.594%



Answer 2: Interest Rate Swaps to hedge the reset risk ...