Borrowing rate options. These options enable an enterprise to ensure a borrowing rate,
while letting it have all the freedom to benefit from a favorable evolution of rates.
Lending rate options. A lending rate options enables an enterprise to place its cash at a
certain minimum rate, while leaving it all freedom to benefit from a favorable movement
of rates.
- Variable Rate Instruments on OTC
Since interest rates fluctuate very widely and are thus very volatile, enterprises very often
borrow or place money at variable rates. Therefore, banks also have put in place the
instruments to cover variable rates.
- Caps and Floors
These instruments are like interest rate options whose exercise takes place several times
during the contract if the buyer of the instruments finds doing so to his advantage.
Cap. Purchase of a cap enables a borrower to fix in advance a maximal borrowing rate
for a specified amount and for a specified duration, while allowing him to avail benefit of
a fall in rates. Naturally, the buyer of a cap pays a premium to the seller.
The enterprise and the bank decide on a reference rate, a cap, a notional amount of
operation, premium to be (expressed in terms of percentage) paid in advance, and the
periodicity of eventual payments.
At every renewal, a comparison is made between the reference rate and the cap. If the
reference rate is higher than the cap, the bank pays to the enterprise the difference of
interest calculated on the notional amount. If the reference rate is lower than the cap, no
payment is made.
Floor. Purchase of a floor enables a lender to fix in advance a minimal rate for placing a
specified amount for a specified duration, while allowing him to avail benefit of a rise in
rates. The buyer of the floor pays a premium to its seller.
A floor is some sort of a series of lending options, having the same characteristics.
Importance of caps and floors. They offer a guarantee of a maximal rate (for caps) and
a minimal rate (for floors), while permitting to benefit from favorable rate movements.
The market of caps and floors is liquid for durations as long as 10 years fro convertible
currencies. A more frequent period is 5 years.