Loans, mortgage

Fearing an increase in interest rates between now and the day it takes out the loan, it enters into a long position in an FRA. The FRA has a fixed rate, called the FRA rate. If the underlying rate at expiration is above the FRA rate, GBT as the holder of the long position will receive a lump sum of cash based on the difference between the FRA rate and the market rate at that time. This payment will help offset the higher rate GBT would be paying on its loan. If the rate in the market falls below the FRA rate, however, GBT will end up paying the counterparty, which will offset the lower rate GBT will be paying on its loan. The end result is that GBT will pay approximately a fixed rate, the FRA rate.
In this problem, the FRA rate is 5.25 percent. We described an outcome in which the underlying rate, 180-day LIBOR, is 6 percent. GBT ends up paying 6% + 2% = 8% on the loan, but the FRA pays off an amount sufficient to reduce the effective rate to 7.24 percent. In all cases, the rate GBT pays is approximately the FRA rate of 5.25 percent plus 200 basis points. This rate is not precisely 7.25 percent, however, because of the way in which the FRA is constructed to pay off at expiration. When LIBOR on 20 August is above 5.25 percent, the FRA payoff on that day reduces the amount that has to be borrowed at LIBOR plus 200 basis points. This reduction works to the advantage of GBT. Conversely, when rates are below 5.25 percent, the amount that must be borrowed increases but that amount is borrowed at a lower rate. Thus, there is a slight asymmetric effect of a few basis points that prevents the effective loan rate from precisely equaling 7.25 percent.
In a similar manner, a lender could lock in a rate on a loan it plans to make by going short an FRA. Lenders are less inclined to do such transactions, however, because they cannot anticipate the exact future borrowing needs of their customers. In some cases, banks that offer credit lines at floating rates might wish to lock in lending rates using FRAs. But because the choice of whether to borrow is the borrower’s and not the lender’s, a lender that uses an FRA is taking considerable risk that the loan will not even be made. In that case, the lender would do better to use an option so that, in the worst case, it loses only the option premium.

In 1997, Congress added a special exemption for family-owned businesses allowing up to $1,300,000 to be transferred without federal estate tax to the extent the assets of the estate were family-owned business property. It required that at least 50 percent of the decedent’s estate consist of qualified family-owned business interests. If a couple planned to take advantage of this provision, they could avoid paying federal estate taxes on estates totaling $2.6 million. To qualify, decedent or a member of his or her family had to own the business for at least 5 years of the 8 years preceding his death and during that time, material participation by decedent or a member of his family in the business operation was required. The excess amount above the exemption equivalent amount will be subtracted in computing the adjusted gross estate. A family-owned business was defined as one where a) at least 50 percent of such entity is owned directly or indirectly by the decedent and members of his family or b) at least 70 percent is owned by members of two families and at least 30 percent is owned by decedent and members of his family, or c) at least 90 percent is owned by members of three families and at least 30 percent is owned by decedent and members of his family. Ownership interests in publicly traded companies and companies located outside of the U.S. were excluded. The participation tests were similar to those used for special use valuation. This special benefit was repealed effective December 31, 2003, but the sunset provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 will reinstate this deduction beginning January 1, 2011, unless the estate tax law is modified before December 31, 2010.