Page 266 - Microsoft Word - 00 ACCA F9 IWB prelims 2017.docx

Chapter 14

3.4 Options

Borrowers may additionally buy options on futures contracts. As with any option, it
gives the chance to protect against downside risk by exercising the option and to
take advantage of favourable movements by letting the option lapse.

3.5 Caps, floors and collars

Borrowers/investors can use interest rate options to set:

 maximum rates (interest rate cap)

 minimum rates (interest rate floor)

 a confined range of rates (interest rate collar)

3.6 Swaps

An interest rate swap is whereby the parties agree to swap a floating
(variable) stream of interest payments for a fixed stream of interest
payments and vice versa.

There is no exchange of principal.

 A company may swap from fixed to floating because it believes
interest rates will move favourably in future

 A company may swap from floating to fixed because it wants
certainty about its cash payments or because it believes that
interest rates will move adversely in future.

Currency swaps are also available whereby debt in different currencies
is swapped.

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