Question

1. Critically discuss THREE factors that could be influencing the interest rate and causing it to change. (Max word count is 50 words)

2. Critically discuss how the following factors may influence may be considered when borrowing additional funds: (Max word count is 90 words)

           i. Term of the loan

           ii.   Fixed vs floating interest rates

           iii. Currency of loan     

3.Describe the construction of an interest rate collar and assess the impact it will have on the interest rate that a borrower may end up paying. (Max word count is 50 words)    

4.Critically assess the additional challenges of performing a currency swap with a foreign organization relative to a domestic interest rate swap. (Max word count is 50 words)

Answer 1

Answer 1:

The three factors that could influence interest rates are:

1) Supply and demand: Interest rates will increase if there is additional demand for credit and conversely it will decrease if demand for credit is decreased.

2) Inflation: If inflation is more, the interest rate may increase. When inflation increases, purchasing power of money is decreased. Hence, lenders will expect higher returns for the decrease in purchasing power.

3) Government policies: Monetary policies of the central banks impacts interest rates. The policies of the central bank will impact monetary liquidity in the system. When banks have more money to lend, interest rate will decrease.   

Answer 2:

I. Term of loan: A longer term of loan will reduce the monthly instalments of the loan to be paid. Conversely, a shorter term will increase the instalments. A shorter term will help in interest savings for the borrower.

II. Fixed vs floating interest rate: Both have their own advantages and disadvantages. In a fixed rate, the monthly instalment will remain same during the term, while in a floating interest rate, the instalment will change as per the prevailing interest rates.

III. Currency of loan: Any volatility in the borrowed currency value versus the home currency will impact value of the loan instalment. Appropriate hedging instruments will have to be adopted to minimize the currency risk.

Answer 3:

An interest rate collar is a kind of hedging instrument that uses derivatives to protect the investor or borrower from interest rate fluctuations. It sets a floor on increasing rates and a ceiling on increasing rates. Call and put options are used to minimize the impact of interest rate fluctuations.

Answer 4:

Swapping with a foreign company is more risky as more credit risk is involved in case of a currency swap with a foreign organization. Intervention by the foreign government or the foreign central bank is also a challenge. A foreign currency swap may be expensive as the intermediary may change additional premium for the risks.