Hedging strategy for loan with interest rate Cap.

Abstract

A bank usually charges a specific nominal interest for a loan, which is influenced by the market’s interest rate. When the market interest rates fluctuate, the customer will face financial loss with the growing burden. Interest rate cap is one of the solutions to anticipate any negative impacts of increasing interest rate, by limiting the maximum interest rate paid by customer to the bank. Thus, customer gets a guarantee against increase in interest rate. To obtain this guarantee, the customer is required to pay a premium. The aims of this paper are to analyze the form of a loan with the interest rate cap strategy, and to discuss Vasicek model approach to determine the amount of the premium. A numerical illustration is given to show the advantage of the interest rate cap strategy. The results show that the interest rate cap will provide protection to the customer as the market interest rates fluctuate. Vasicek model states that the price cap interest rate can be expressed as an expected value of a random variable that has bivariate normal distribution. Numerical results show that this strategy provides benefits in the form of lower amortization cost than that of a loan without interest rate cap.