IX: Market Innovations 28: Interest Rate Agreements

Interest Rate Agreements Ceiling The buyer pays a premium and in return is compensated if the interest rate rises above the ceiling. Floor The buyer pays a premium and in return is compensated if the interest rate falls below the floor.

Ceiling Cemex Inc buys a ceiling from the Citibank The reference rate is LIBOR The ceiling is set at 6% The notional principal amount is $10m The agreement calls for quarterly settlement for 1 year. The agreement is signed January 1, 2007

Ceiling Date LIBOR Payment to Cemex April 1, 2007 5.9% $0. July 1, 2007 6.1% 0.1% x $10m 4 $2,500. October 1, 2007 6.8% 0.8% x $10m 4 $20,000. January 1, 2008 5.8%

Ceiling © Oltheten & Waspi 2012

Floor © Oltheten & Waspi 2012

IX: Market Innovations Pollution Allocation Units

Natural Resource Economics In production factors of production are used to the point where marginal cost = marginal revenue Economic Allocation Rights add the cost of open access natural resources back into the production function.

Pollution Rights Sulphur Dioxide Emission Unit allows the emission of 1 ton of SO2 up to the expiration year. 1 ton SO2 emitted in 2009 must be paid for with a 2009 SO2 unit or a banked pre-2009 unit In March of 2010 the EPA issues units based on historical emissions and auctions 2010 and 2017 units http://www.evomarkets.com/

Pollution Rights The old factory can reduce emissions by spending $500 1st ton $600 2nd ton $700 3rd & 4th ton The new factory can reduce emissions by spending $200 1st & 2nd ton $300 3rd & 4th ton 6 tons 6 tons

Pollution Rights Congress mandates a reduction of 2 tons by each factory.

Cost of reducing emissions 4 tons The old factory $500 1st ton $600 2nd ton $700 3rd & 4th ton The new factory $200 1st & 2nd ton $300 3rd & 4th ton $1,100 $400 4 tons TOTAL COST: $1,500

Cost of reducing emissions 6 tons The old factory $500 1st ton $600 2nd ton $700 3rd ton The new factory $200 1st & 2nd ton $300 3rd & 4th ton Buy 2 extra pollution credits for $400 each Sell 2 extra pollution credits for $400 each 2 tons TOTAL COST: $1,000

Cost of reducing emissions The old factory $500 1st ton $600 2nd ton $700 3rd ton The new factory $200 1st & 2nd ton $300 3rd & 4th ton Cost of credits $800 < $1,100 $1,000 +$800=$200 $200 < $400 TOTAL COST: $1,000 < $1,500

Drop Options

Registered to: John Q. Student Drop Options Each student entering the College of Business will receive two Drop Options. Assumes four years to graduation plus one year buffer zone DROP OPTION Entitles the student to drop one 3 hour course at any time, up to an including the last day of class, without penalty. Expires: May 15, 2014 Registered to: John Q. Student Can be used by John Q. Student or sold to another student.

Drop Options Drop Options will trade in the open market.

Drop Options Joe is a well-motivated student who plans his program of study and follows it. He never uses his drop options. In his final semester he sells his drop options for $300 each.

Drop Options Susan drops Marketing 306 but sells her other drop option in her senior year for $320.

Drop Options Sterling Silverspoon III is drops two classes in his freshman year. He needs two more drop options to repeat Finance 300 (twice). He pays $300 for the first and $320 for the second. He drops Corporate Finance once ($320) and Futures and Options once ($330). He drops Financial Engineering once ($300) and decides to take Investments instead.

The End