INTEREST RATE CAPS AND FLOORS

Part 1: Respond to the follow discussion:

  • • 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.

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Part 2: Respond the following classmate’s discussion:

“Interest rate caps and floors are options like contracts, which are customized and negotiated by two parties. Caps and floors are based on interest rates and have multiple settlement dates.  An investment in a derivative using an interest rate cap or floor requires the buyer to pay a premium to purchase the option, so the buyer faces some form of credit risk.  An interest rate cap protects the buyer from interest rates rising above the strike rate. Floors set a minimum interest rate payment because if interest rates fall below the strike rate, the floor holder is protected. In assessing the volatility risk with an investment in a derivative using an interest rate cap or floor in today’s marketplace, because of the high volatility with an investment in a derivative, having some form of protection is an excellent way to hedge one’s investment. Still, with all investments and markets, there are no guarantees or certainty. As an investor, I would want to use these techniques to limit exposure to changes in market interest rates. I believe it’s a good idea.

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or a put option.  The Black-Scholes pricing model is largely used by options traders who buy options that are priced under the formula calculated value and sell options that are priced higher than the Black-Scholes computed value.  The Black-Scholes model is useful because it is like the value of interest-rate cap/floor investments.  This model uses factors and formulas that are based on assumed variables but may not translate to real-world marketplace scenarios. Factors will change throughout the market cycle, and they will never be predictable, which is one flaw with using this model.  To minimize pitfalls with this method, investors must monitor market volatility changes, and other market developments.   Overall, the Black-Sholes pricing model is another investment technique that is effective and accurate.”

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