Interest rate floors

Discussion in 'SA5' started by r_v.s, Mar 7, 2015.

  1. r_v.s

    r_v.s Member

    Would you please explain how one could hedge the risk of falling interest rates with an interest rate floor? In the April 2007 paper, the company in q1 has a fixed rate loan at 8%. When interest rates fall this borrowing becomes expensive. How does the floor help?

    What is the 'on-sell'ing that part v talks about does that mean, the company buys some other product and sells it as its own??
     
    Last edited by a moderator: Mar 7, 2015
    r_v.s, Mar 7, 2015
    #1
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    The risk is described in the section above, whereby the company will struggle to pay the high fixed charge on debt if inflation (and rates) are unexpectedly low for a long time. (I must admit that this is a tricky concept, and I doubt manyt companies are in this situation - the assumption is that the profits rise and fall quite dramatically with interest rates). If the company buys a floor, then when rates fall and the long term fixed debt becomes hard to finance, there will be a floorlet to exercise, which will bring in money to the holder (ie the company). This will ease the pain and cashflow issues that it is experiencing.
    On the second part, you are right. The idea is that the company buys whisky on the forward / futures markets, takes delivery, and sells it on as its own.
     
    Colin McKee, Mar 9, 2015
    #2

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