Question

QUESTION 8

An FI would normally purchase a cap if it was funding fixed-rate assets with variable-rate liabilities.

True

False

Answer 1

Solution:

Caps and floors are used to hedge against interest rate fluctuations.

For e.g., a borrower who is paying the variable rate of interest on loan can protect himself against increase in rates of interest by buying a cap at fixed rate of interest say 2%. If the interest rate exceeds 2% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively "capped" at 2% from the borrowers' point of view.

Therefore FI would normally purchase a cap if it was funding fixed rate assets with variable rate liabilities because in that case its income is fixed, however FI liabilities may vary due to fluctuation in interest rates. Therefore in order to hedge variable rate liabilities FI will purchase a cap. Hence statement is true.