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• What is (London interbank offer rate )LIBOR? • How is it used to fight interest rate volatility by a loan taker corporate in the long run? • How petroleum volatility can be fought in the long run with futures and options in the commodity market.
Volatility in the market can be fought using the various market instruments and derivatives like futures, options, swaps, caps & floor interest rates etc.
LIBOR is the interest rate at which banks can borrow funds in marketable size from other banks in London interbank market. It is fixed on daily average basis.
To fight the interest rate volatility, caps and floor rates are used. In case of a loan taker corporate, a lower interest rate is expected and thus if the market rate is above cap, cap rate will prevail and if the market rate is below floor, floor rate will prevail. However, if the interest rate is in between cap and floor rate, market rate will prevail.
Taking the seller of petroleum products' side, volatility in terms of the price preaviling on the future sale date/ transaction date can be fixed today in the futures market. Thus, on the date of expiration, the seller would either sell at the pre-decided future price or the spot price on the date of expiration, whichever is higher.
In the case of options, the seller of pretroleum product would buy a put option (as he is the seller of goods) by paying the put option premium today to sell his product on the expiration date at the exercise price. However, on the date of expiration, the buyer of the put option will either exercise or lapse his put option depending upon the market price at expiration. If the spot price on the date of expiration is higher than the pre-determined exercise price, the seller would prefer to sell the petroleum in the market and lapse the options contract and vice versa.
Thus in both futures and option contract, the seller of petroleum has limited his lowest selling price today itself whereas he can make sales at the higher selling price over and above the pre-determined price by cancelling or lapsing the contract.
