You are an assistant analyst at a financial consulting company. You have been asked to prepare a report for your manager who is advising a new client on using interest rate derivatives to hedge against interest rate movements. The client is hoping to increase production capacity by 50% in the next two to three years due to increasing demand for its products. The client will need to obtain finance to fund the expansion. The yield curve is currently upward sloping; however, the client is worried that possible Federal Reserve actions to reduce inflation may result in a downturn in the economy. As the client already has floating interest-based debt, it is enquiring about hedging potential interest rate risk using swaps. You are required to write a short report that addresses the following concerns so that your manager can present it to the client: a) In what ways could the client use swaps to reduce exposure to interest rate movements on its cost of debt? Include an explanation of any disadvantages of using a hedge versus no hedge at all. b) In what ways could the client use an interest rate cap to reduce exposure to interest rate movements on its cost of debt? Include an explanation of any disadvantages of using the cap vs. no hedge at all.
You are an assistant analyst at a financial consulting company. You have
been asked to prepare a report for your manager who is advising a new
client on using interest rate derivatives to hedge against interest rate
movements.
The client is hoping to increase production capacity by 50% in the next two
to three years due to increasing demand for its products. The client will need
to obtain finance to fund the expansion.
The yield curve is currently upward sloping; however, the client is worried
that possible Federal Reserve actions to reduce inflation may result in a
downturn in the economy. As the client already has floating interest-based
debt, it is enquiring about hedging potential interest rate risk using swaps.
You are required to write a short report that addresses the following
concerns so that your manager can present it to the client:
a) In what ways could the client use swaps to reduce exposure to
interest rate movements on its cost of debt? Include an explanation
of any disadvantages of using a hedge versus no hedge at all.
b) In what ways could the client use an interest rate cap to reduce
exposure to interest rate movements on its cost of debt? Include an
explanation of any disadvantages of using the cap vs. no hedge at
all.
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