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CHAPTER 21
Intermediate- and Long-Term Debt
QUESTIONS
1. Which party bears interest-rate risk exposure in a fixed rate loan? in a floating rate loan? 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.
2. Why are caps and collars considered insurance products? 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.
3. Why would any...