Sunday, March 15, 2009

interest rate risk

Most borrowing is undertaken on variable interest rate terms . borrowers will have made assumptions about the intersert rate that they will be charged in their plans to repay the borrowing . they are therefore exposed to the risk that their interest rate assumptions turn out be too optimistic.this could have asignificant effect on the borrower is capacity to repay.
fixing the interest rate in advance produces more certainty for both the borrower and the lender .if this is not possiple ,or the fixed rate is thought to be too unattractive hedging through instruments such as interest rate swaps ,forward rate agreements,interest rate caps ,floor and collars can be considered.
An interest rate swap is an exchange of interest paymet obligations between two parties without an exchange of the underlying principle repayment obligations .fixed interest obligations can be swapped for floating and vice versa.
A forward rate agreement (FRA) enables the customer to protect itself against adverse interest rate movements when there is aknown interest -related requirement at aKnown future data .THIS Is Achieved without incurring any commitment to take up the loan or place the deposit involved through the mechanism of agreeing with the bank afuture interest rate and then paying or receiving the interest differential between the rate agreed and the market rate on the agread settlement data .
interest rate caps ,floors and collars are all forms of interest rate option contracts that enable interest costs to be managed within arange agreed in return for afee .the customer does not have to exercise the option if it is not in his interests to do so .

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