If interest rates fall, futures prices will rise, so buy futures now (at a relatively low price) and sell later (at the highest price). The profit of futures contracts can be used to compensate for the fall in interest rates. The first chapter provides an overview of existing derivatives and the structure and function of swaps. In addition, the different types of hedging-oriented traders are described. These agreements allow a company to borrow or deposit funds as if it had agreed on an interest rate that will apply for a certain period of time. For example, the period could start in three months and last nine months thereafter. Such a FRA would be called a 3-12 deal because it starts in three months and ends after 12 months. Note that both parts of the synchronization definition begin with the current time. The option holder must make a payment to the option holder for the difference between the market interest rate and the exercise rate. To solidify these points, let`s assume that a company expects to borrow $2 million in two months for a period of three months. It anticipates an increase in the LIBOR rate, which currently stands at 4% per year, and has therefore decided to cover the risk of rising interest rates with the borrower`s option. He buys a borrower`s option at an exercise rate of 4.50%, which has a premium of $6,000.
The option applies to an expiry date in two months, and the rating interest period is three months. If the three-month LIBOR at the expiry date is 6.50%, the option is exercised. The Company will borrow $2 million at the market rate of 6.50% (LIBOR +1%) for three months and will receive a cash payment of $10,000 ($2 million X 3/12 X()%) from the option holder. The Company`s interest charges can be summarized as follows: Interest on loans ($2 million X 3/12 X 7.5%) $37, Add: Option cost (premium) 6, Less: Cash received from option author ($10,000.00) $33, Pinnacle Research Journals 19 Therefore, the net cost of inefficient interest of $33 equals $2 million in borrowings for three months at approximately ($33,500/$2 million) X (12/3) X 100% = 6.7%. The option thus offset some of the effects of the increase in LIBOR. A lender`s option gives its holder the right, but not the obligation, to issue a fictitious loan for a specific amount and term of capital, starting from a future date (option expiry date) at a fixed interest rate. A lender`s option is therefore a put option on a fictitious short-term loan and the option is exercised when only the current market interest rate is lower than the exercise rate of the option. .