International Students is a charity providing reasonably priced housing in London for students from overseas. The charity wants to build three new hostels. It projects that in six months' time, it will need to borrow £5 million and this can be paid back over 20 years from rents and donations, provided that interest rates over the next 20 years do not rise above 7.5%. Is there a way the charity can protect its loan against a rising interest rate?

Structure of the chapter

In the first part of the chapter, we discuss four ways to protect an investment or a loan against an adverse interest rate movement.

In section 5.1, we discuss the forward rate. This is the interest rate that current rates imply will be in force during a given future time period. We show how to calculate the forward rate and how it is always possible to obtain the forward rate. We would like to have at our disposal a structure for interest rates similar to a forward contract (described in Chapter 2). This is the forward rate agreement and is described in section 5.2. Like forward contracts, forward rate agreements are not traded – they are bought ‘over the counter’. It would be useful to have a solution to the problem faced by International Students that involved an asset that was traded. We provide two: in section 5.3 we discuss swaps and in 5.4 caplets and caps and floorlets and floors.