Tag Archives | Financial Derivative

Fixed Interest Rate vs Floating Interest Rate

See Also:
Effective Rate of Interest Calculation
What is Compound Interest
When is Interest Rate Not as Important in Selecting a Loan?
Nominal Interest Rate
Interest Rate Swaps

Fixed Interest Rate vs Floating Interest Rate

A loan can have a fixed interest rate or a floating interest rate. If the loan has a fixed interest rate, the interest rate remains constant for the duration of the loan. If the loan has a floating interest rate, also called a variable interest rate, then the interest rate fluctuates over the duration of the loan. Floating rates typically fluctuate with the overall market, with an underlying index, or with the prime rate.

Fixed interest rates and floating interest rates can apply to any type of debt or loan agreement. This includes monetary loans, credit card bills, mortgages, auto loans, and corporate bonds. Fixed rates and floating rates can also apply to financial derivative instruments.

Advantages and Disadvantages

Fixed Rate Loan

The primary advantage of a fixed interest rate loan is the elimination of uncertainty. Once the loan agreement is finalized, the value of the future interest payments is known.

A fixed interest rate can also be advantageous to the borrower (disadvantageous to the lender) if the market rates rise above the fixed rate, giving the borrower implicit gains (and the lender implicit losses). A fixed rate can be advantageous to the lender (disadvantageous to the borrower) if the market rates fall below the fixed rate, giving the lender implicit gains (and the borrower implicit losses).

Variable Rate Loan

The primary advantage of a floating interest rate is that it moves with the market rates. Of course, this can also be a disadvantage, depending on which way the market rates move and which side of the transaction the party is on.

A rise in market rates can increase the cost of the loan for the borrower and increase the interest income for the lender. Conversely, a fall in market rates can decrease the cost of the loan for the borrower and decrease the interest income for the lender.

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Hedge Funds

See Also
Currency Exchange Rates
Hedging Risk
Currency Swap
Transaction Exposure
Exchange Traded Funds

Hedge Funds Defined

What is a hedge fund? A hedge fund is a private investment portfolio that makes aggressive speculative investments. Because hedge funds often have a very high minimum investment requirement, hedge fund investors are typically only institutional investors and wealthy individuals. The hedge fund manager manages the hedge fund investments. Because hedge funds are private – often structured as private partnerships – they are not subject to the same SEC regulations as other funds, such as mutual funds.

Hedge Fund Investing

Hedge fund investing is fairly illiquid. This is because hedge funds often require investors to commit their invested capital for a certain period of time, sometimes a year or longer. During this period the investor’s capital is locked into the hedge fund. Therefore, the investor cannot pull out the invested funds. Hedge funds often require investors to lock in their funds so the hedge fund manager can engage in complicated investments without worrying about having the capital pulled out from under him.

Costs of Hedge Funds

The costs of hedge funds include management fees and a percentage of any profit that goes to the hedge fund manager. Call this percentage of profit that goes to the hedge fund manager the hedge fund carry. Hedge fund investments often include combinations of exotic financial instruments, such as credit default swaps, leverage, options contracts, forward contracts, futures contracts, long positions, short positions, and other financial derivatives.

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Financial Instruments

See Also:
What is a Bond
Required Rate of Return
Return on Asset
Commercial Paper
Hedging Risk
Histogram

Financial Instruments and Securities

Financial instruments are contracts that represent value. They come in many varieties. In fact, financial managers and bankers have a lot of leeway in creating and issuing financial instruments. The Securities and Exchange Commission (SEC) regulates publicly traded financial instruments; however, the SEC less stringently regulates private placement instruments. Most financial instruments fall into one or more of the following five categories: money market instruments, debt securities, equity securities, derivative instruments, and foreign exchange instruments.


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Money Market Instruments

Money market instruments are highly marketable short-term debt securities. Furthermore, money market instruments are generally low-risk investments. Because of this, they offer yields that are lower than riskier stocks and financial instruments.

Often, investors trade money market instruments in large denominations among institutional investors. However, some money market instruments are available to individual investors via money market funds, or mutual funds that pool money market instruments.

Money market instruments include treasury bills, repurchase agreements, certificates of deposit, commercial paper, bankers’ acceptances, Eurodollars, and federal funds.

Debt Securities

Debt securities are longer-term debt instruments. With debt instruments, the issuer is essentially borrowing money from the investor. The investor plays the role of a lender lending money to the issuing entity. Longer-term debt securities often yield higher returns than money market instruments. Debt instruments also represent a claim on the assets of the issuing entity.

Debt securities are often called fixed-income securities. This is because the investor or lender often predetermines the terms of the debt instrument. For example, a debt instrument will be issued with a certain maturity, a certain principal amount, and a set coupon rate. However, while debt securities are often called fixed-income securities, this does not mean they yield a fixed stream of payments – debt securities’ returns can fluctuate and vary.

Examples of debt securities include: treasury notes, treasury bonds, inflation-protected treasury bonds, federal agency debt, international bonds, municipal bonds, corporate bonds, junk bonds, mortgages, mortgage-backed securities, and other types of debt.

Equity Securities

Equity securities represent shares of ownership in a company. In addition, equity securities often come with voting rights. They represent the shareholders’ interest in the issuing company and a residual claim on the company’s assets. This means if the issuing company goes bankrupt and has its assets liquidated, then the equity holders only get their money back after all other relevant claimants have been paid what they are owed.

Equity securities may be traded publicly on stock exchanges, they may be traded in over-the-counter (OTC) transactions, or they may be exchanged and held privately. Types of equity securities include common stock, preferred stock, and American Depository Receipts (ADR).

Financial Derivative Instruments

A financial derivative instrument is a contract that derives its value from an underlying asset or factor. In short, the value of a derivative depends on the value of something else. When the value of the underlying factor changes, the value of the derivative instrument also changes. Derivatives are often used for speculation, for leveraging a position, or for hedging risk.

Common derivatives include futures, forwards, options, and swaps. Common underlying assets or factors include stocks, bonds, currency exchange rates, commodity prices, market indices, and interest rates. However, derivatives can derive their value from almost anything, including weather data and political election outcomes.

Foreign Exchange Instruments

Another category of financial instruments is foreign exchange instruments. These are contracts involving different currencies. There are many currencies in the world, and there are several different instruments commonly used to trade in currencies.

The value of one currency relative to another depends on the exchange rate between the two currencies. Consider exchange rates either fixed or floating. Types of foreign exchange instruments include spot contracts, forward contracts, options, futures, and swaps.

Exchange foreign currencies for investment and speculative purposes and for hedging risk. You can trade foreign currencies all over the world twenty-four hours a day via banks and brokerages. The foreign exchange market is the largest market in the world. Consider speculating in foreign exchange markets very risky.

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