1. IX: Market Innovations
28: Interest Rate Agreements

2. 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.

3. 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

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

5. Ceiling
© Oltheten & Waspi 2012

6. Floor
© Oltheten & Waspi 2012

7. IX: Market Innovations
Pollution Allocation Units

8. 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.

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. Drop Options

16. 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.

17. Drop Options
Drop Options will trade in the open market.

18. 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.

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

20. 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.

21. The End