This is for class Financial Risk Analysis (textbook is called; Modern Financial

Question

This is for class Financial Risk Analysis (textbook is called; Modern Financial Markets- Prices, yield, and risk analysis)

"Interest Rate Caps and Floors" Please respond to the following:

Assess the volatility risk with an investment in a derivative, using an interest rate cap or floor in today’s marketplace. Indicate whether or not you would advise financial institutions to engage in this type of investment. Provide support for your response.

Assess the effectiveness of using the Black-Scholes model to value cap and floor type investments, indicating how any pitfalls with this method of valuation can be minimized. Provide support for your response.

Please provide one citation/reference for your initial posting that is not your textbook. Please do not use Investopedia or Wikipedia.

Explanation / Answer

Interest rate Caps and Floors:

An interest rate cap is designed to protect an investor who has borrowed funds on a floating interest rate basis against the risk of paying very high interest rates. More specifically, it is a collection of caplets, each of which is a call option on e.g., the LIBOR rate at a specified date in the future. Banks and institutions will use caps to limit their risk exposure to upward movements in short term floating rate debt. Caps are equally attractive to speculators as considerable profits can be achieved on volatility plays in uncertain interest rate environments. This financial instrument is primarily used by issuers of floating rate debts in situations where short term interest rates are expected to increase.

Similarly, an interest rate floor on the other hand, guarantees a lower bound for the rate of interest received on an investment. The rate floor itself provides a periodic payment based upon the positive amount by which the strike rate exceeds the reference rates. Floors are used in times of decreasing short term interest rates by money managers trying to obtain higher cash returns on floating rate investments. Compensation is paid to the seller in return for the interest rate guarantee.

Risk associated with Caps and Floors:

The major advantages of caps are that the buyer limits his potential loss to the premium paid, but retains the right to benefit from favourable rate movements. A cap limits exposure to rising interest rates, while retaining the potential to benefit from falling rates. The disadvantages of caps are that the premium is a non-refundable cost, which is paid upfront by the buyer, and the negative impact of an immediate cash outflow. Caps can theoretically lose all their value if they expire as out-the-money or start to approach their expiry dates.

For sellers of Caps and Floor, no risk is encounter in this position while the buyers face the risk coming from the non-performance of that contract as the strike rate. Apart form thid te buyer also faces the default risk from seller.

My recommendation:

The floating interest rate is always a crucial factor people would like to predict in the financial market. When investors lend or borrow money from bank, the floating interest rate will be a risk that they have to manage with their asset. By the help of these interest rate derivatives, corporations enjoy much freedom in managing financial assets and liabilities. In conjunction with other financial instruments, Caps and Floors may help remapping the corporation risk structure. In short, interest rate caps and floors are essential tools which hedge the risks.

Effectiveness of using the Black-Scholes model to value cap and floor type investments:

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate. It is the simplest and most common valuation method of interest rate caplets. However, the Black–Scholes model disagrees with reality in a number of ways, some significant. It is widely used as a useful approximation, but proper use requires understanding its limitations – blindly following the model exposes the user to unexpected risk.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.