In the example above, the loan involved only a single payment and, therefore, we had only one setting of an interest rate to worry about. Many loans are floating-rate loans, meaning that their rates are reset several times during the life of the loan. This resetting of the rate poses a series of risks for the borrower.
Suppose a corporation is taking out a two-year loan. The rate for the initial six months is set today. The rate will be reset in 6, 12, and 18 months. Because the current rate is already in place, there is nothing the corporation can do to mitigate that risk. It faces, however, the risk of rising interest rates over the remaining life of the loan, which would result in higher interest payments.
One way to control this risk is to enter into a series of FRA transactions with each component FRA tailored to expire on a date on which the rate will be reset. This strategy will not lock in the same fixed rate for each semiannual period, but different rates for each period will be locked in. Another alternative would be to use futures. For example, for a LIBOR-based loan, the Eurodollar futures contract would be appropriate. Nonetheless, the use of futures to manage this risk poses significant problems. One problem is that the Eurodollar futures contract has expirations only on specific days during the year. The Chicago Mercantile Exchange offers contract expirations on the current month, the next month, and a sequence of months following the pattern of March, June, September, and December. Thus, it is quite likely that no contracts would exist with expirations that align with the later payment reset dates. The Eurodollar futures contract expires on the second London business day before the third Wednesday of the month. This date might not be the exact day of the month on which the rate is reset. In addition, the Eurodollar futures contract is based only on the 90-day Eurodollar rate, whereas the loan rate is pegged to the 180-day rate. Although many dealer firms use the Eurodollar futures contract to manage the risk associated with their over-the-counter derivatives, they do so using sophisticated techniques that measure and balance the volatility of the futures contract to the volatility of their market positions. Moreover, they adjust their positions rapidly in response to market movements. Without that capability, borrowers who simply need to align their interest rate reset dates with the dates on which their derivatives expire can do so more easily with swaps. Nevertheless, an understanding of how FRAs are used will help with an understanding of this application of swaps.
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Floating-rate loan
Payable On Death (POD) or Transfer On Death (TOD) Registration
Savings accounts may be made payable on death of the owner to a named beneficiary, if living.11 Securities may be registered in beneficiary form that indicates the present owner and the intended beneficiary who will become the owner upon the death of the present owner.12 Sole owners or multiple owners with right of survivorship may use this form to designate a beneficiary to take ownership at the deaths of all owners. This form is created by using the words “transfer on death” or “TOD” or “pay on death” or “POD” after the name of the registered owner and before the name of the beneficiary. On proof of death of all owners and compliance with other requirements of the registering entity, the security may be reregistered in the name of the beneficiary. If no beneficiary survives the owner, the security belongs to the estate of the owner. Debts, taxes, and expenses of administration, including allowances to the surviving spouse and minor or dependent children take precedence over the beneficial owner’s interest if other estate assets are insufficient. Registering entities are not required to offer this form, but many do offer it.
Qualified Disclaimers
With reference to the estate tax, gift tax, and generation skipping transfer taxes, if a recipient makes a qualified disclaimer with respect to any interest in property within the estate of decedent or donor, the property will be treated as if it had never been transferred to the recipient.
An example of when this might be used wisely is as follows: John Doe dies unexpectedly and his will leaves everything to his wife and the will was written 30 years ago. If the wife now owns considerable assets in her name, she might prefer that part of the property in her husband’s estate pass to their children instead. By properly disclaiming some of the property designated to pass to her, she could reduce her estate taxes at her death (see an attorney for details on how this can be done).
Survivor’s Homestead Rights
Homestead rights in Oklahoma may consist of an estate in land and personal property as well as exemption from certain debts. The homestead of any family living in a rural area shall consist of not more than 160 acres. It may be in one or more parcels to be selected by the owner. The homestead in a city or town, or platted area, and occupied as a residence only shall consist of not more than one acre of land. The statute limits an urban homestead to a value of $5,000, but in no case will it be reduced to less than one-quarter of an acre. Some of the personal property not subject to administration proceedings are family pictures, church pew, lot or lots in a burial ground, Bible, school books, other books not in excess of a value of $100, clothing, food and fuel for one year, and household and kitchen furniture. This property is to be delivered immediately by the executor or administrator to the surviving spouse and children, if any.
Upon the death of either the husband or wife, the survivor may continue to possess and occupy the whole home-stead. It is not subject to administration proceedings until it is disposed of according to law. Also, upon the death of both the husband and wife, the children may continue to occupy the homestead until the youngest child reaches the age of majority. The homestead right is similar to a life estate. It comes into play when one spouse owns the homestead and dies. The surviving spouse may occupy the homestead until death. At the death of the surviving spouse, if there are no minor children, the property will pass to the heirs of the spouse who owned the homestead. The homestead rights are designed to prevent the spouse or minor children from being ejected from their home at the death of the spouse who held title to the property. The homestead is also not subject to the payment of any debt or liability contracted by either the husband or wife, except for liens such as mortgages on the homestead.