In each of the following cases, indicate whether an interest rate cap, floor, collar, or reverse collar is an appropriate position for a hedge. Recommend a specific position.
a. A bank loan customer wants to borrow at a fixed 8 percent rate and the bank only lends at floating rates.
b. A bank has agreed to pay a large depositor a fixed 1.5 percent on balances over the next three years regardless of rate moves. The bank expects rates to fall on similar deposits over this period.
c. Your bank owns adjustable rate mortgages (ARMs) that are priced at three month LIBOR plus 1 percent. There is an annual cap on the allowable rate increase equal to a maximum of 1 percent a year. Thus, if LIBOR rises by 3 percent, the bank can raise the ARM rate just 1 percent. How can the bank effectively remove this cap?