Assignment

Part 1

"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.

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

Part 2 respond to statement

Interest rate derivatives can be an effective way to cut exposure to economic risk. Interest rate caps create a ceiling on floating rate interest costs. When market rates move above the cap rate, the seller pays the purchaser the difference. A company borrowing on a floating rate basis when 3 month LIBOR is 6% might purchase a 7% cap, for example, to protect against a rate rise above that level. If rates subsequently rise to 9%, the company receives a 2% cap payment to compensate for the rise in market rates. The cap ensures that the borrower's interest rate costs will never exceed the cap rate. Interest rate floors are the mirror image of a cap. When market rates fall below the floor rate, the seller pays the difference. A 6% floor triggers a payment to the purchaser whenever market rates drop below 6%. Asset managers buy floors to guarantee a minimum return on floating rate assets. They sell floors to generate incrementally higher returns. Debt managers buy floors to protect against opportunity losses on fixed rate debt when rates fall. They may sell floors as a component of a hedge strategy involving other derivative instruments.

Caps and floors greatly enhance a treasurer's flexibility in managing financial assets and liabilities. Used together or in combination with other hedging instruments, caps and floors are efficient tools for reconfiguring a company's financial risk profile.

My advice to a financial institution would depend on their current financial standings and goals.

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. The, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments, blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream. Anyone who has followed the crisis will understand that the real economy of businesses and commodities is being upstaged by complicated financial instruments known as derivatives. These are not money or goods. They are investments in investments, bets about bets. Derivatives created a booming global economy, but they also led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump. And it was the Black-Scholes equation that opened up the world of derivatives.

The equation itself wasn't the real problem. It was useful, it was precise, and its limitations were clearly stated. It provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be traded before they matured. The formula was fine if you used it sensibly and abandoned it when market conditions weren't appropriate. The trouble was its potential for abuse. It allowed derivatives to become commodities that could be traded in their own right. The financial sector called it the Midas Formula and saw it as a recipe for making everything turn to gold. But the markets forgot how the story of King Midas ended.

Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world's manufacturing industries over the last century. The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.