Insurance products are contingent claims. The insured party pays a premium for the contract (for example, an automobile policy). Should the specified condition (for example, an automobile accident) not occur, no payment is made under the policy. However, if the condition does take place, the insurer pays according to the contract’s terms. Caps and collars work exactly in this way. A borrower who wishes to limit its interest rate exposure pays a premium to the writer of the contract. Should interest rates remain below the cap or within the collar, no payment is made to the borrower. However, if rates move outside the specified limits, the writer of the contract reimburses the borrower, in this case by the amount of the interest payment resulting from the difference between the actual and contract rates.
To the extent that risk means future uncertainty, both parties bear risk when interest rates are floating that they do not bear when rates are fixed. However, most lenders and borrowers are primarily concerned with the possibility that interest rates will move against them. Accordingly, the risk depends on the direction in which rates might move. In a fixed rate loan, the risk comes from not being able to benefit from a change in rates. The lender bears the risk that interest rates will rise, and it will be unable to increase the rate it is charging; the borrower bears the risk that rates will fall, and it will be unable to reduce the rate it is paying. In a floating rate loan, the risk comes from being hurt by a change in rates. The lender bears the risk that interest rates will fall, and so will its earnings; the borrower bears the risk that rates will rise, and so will the amount it is paying in interest.
Why would any company purchase a floor, since it keeps its interest payments up when interest rates fall?
While borrowers do not purchase floors by themselves for this reason, they do purchase them along with caps to create collars. Since the insurer benefits from a floor, it is willing to sell a collar for a lower premium than just a cap alone. The borrower gets the protection of the cap at a lower price than by simply purchasing the cap alone.
Either they wish to lower the cost of their financing or better match their financing to the cash flows from their operations, thereby providing some hedging. Each of the three types of swaps usually lowers the cost of financing. In addition each changes the company’s risk exposure:
a. A basis swap? A basis swap is an exchange of loan obligations based on different underlying reference rates. A company can reduce its financing risk if it can match the basis of its financing to the characteristics of its income stream.
b. A fixed-floating swap? A fixed-floating swap is an exchange of loan obligations where one is at a fixed rate and the other at a floating rate of interest. A company can reduce its financing risk if it can match its interest rate exposure to the characteristics of its income stream.
c. A currency swap? A currency swap is an exchange of loan obligations where the interest payments, principal payments, or both are denominated in different currencies. A company can reduce its financing risk if it can match its foreign currency exposure to the characteristics of its income stream.
A collar limits the amount of interest rate movement that can affect a borrower. A collar with a wide band has very little effect, cutting off only drastic changes to interest rates. As the bands of the collar narrow, the borrower is insulated from greater interest rate movements. At the extreme of a very narrow collar, the borrower is hardly affected at all by interest rate movements, and its payments against the loan are (nearly) the same as if the loan carried a fixed rate in the first place.
Three conditions in which a term loan is appropriate are:
(1) to finance an asset of intermediate-term life, thus hedging the loan with the cash thrown off by the asset,
(2) as a substitute for a line of credit in a firm with an operating cycle longer than one year, and
(3) as a “bridge loan” to finance the company during a period when its needs are uncertain or financial market conditions make it difficult or expensive to obtain longer-term financing.
What are the similarities and differences between:
a. An equal payment term loan? An equal payment loan is a loan which is repaid in a series of payments of identical amount, each containing the appropriate amount of interest and some repayment of principal.
b. An equal amortization term loan? An equal amortization loan is a loan in which the principal is repaid in equal amounts over the life of the loan and the appropriate amount interest is then added on to each principal repayment.
The two loan forms are similar in that both are repaid in a specified number of payments, evenly spaced over the loan period. They differ in two primary respects:
- While the payments under an equal payment loan are all the same amount, the payments under an equal amortization loan decline over the loan’s life since the declining loan balance leads to lower interest expense.
- On the other hand, while the amount of principal repaid with each payment in an equal amortization loan is constant, the principal repayment in an equal payment loan increases over the loan’s life. Less interest is due with each payment leaving more room for repayment of principal.
A balloon and bullet each involve a large final payment to repay a loan. The difference is the amount. A bullet is the full principal amount of the loan; no principal is paid off prior to the date of the bullet. By contrast, a balloon payment is normally less than the full loan amount and some of the loan principal is paid back prior to the date of the balloon payment.
a. Direct lease – a lease with only one lessor who owns the leased asset.
b. Leveraged lease – a lease in which the lessor leverages its position by borrowing in order to purchase the asset to be leased.
c. Sale and leaseback – the act of selling an asset to a lessor and them promptly leasing it back to free up the cash invested in the asset while maintaining its use.
d. Full service lease – a lease for an asset and also its operation and maintenance.
e. Net lease – a lease for the asset only, without any supporting services.
f. Operating lease – a lease providing for the use of an asset for a short time relative to the economic life of the asset, much like a rental.
g. Financial lease – a lease providing for the use of an asset for a period close to or equal to the full economic life of the asset, much like buying the asset using an intermediate- or long-term loan.
(1) specify the loan’s characteristics,
(2) identify collateral if any, and
(3) contain the protective covenants demanded by the lender to help assure the loan is repaid.