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CMA Final · Strategic Financial Management · Interest Rate Derivatives

A company with a floating-rate borrowing buys an interest rate cap at a strike of 8% on a notional of Rs 50 crore for one year with quarterly resets, paying an upfront premium of Rs 4 lakh. The reference rates at the three remaining resets are 7.6%, 9.2% and 10.0% p.a. (the first period is not covered). Using 3-month periods (0.25 year), what is the total cap payout and net gain after premium?

Total payout is Rs 40 lakh and the net gain is Rs 36 lakh. The 7.6% reset pays nothing; 9.2% pays 1.2% for a quarter on Rs 50 crore, Rs 15 lakh; 10% pays Rs 25 lakh. Subtracting the Rs 4 lakh premium gives Rs 36 lakh.

  1. APayout Rs 24 lakh; net gain Rs 20 lakhCorrect
  2. BPayout Rs 20 lakh; net gain Rs 16 lakh
  3. CPayout Rs 40 lakh; net gain Rs 36 lakh
  4. DPayout Rs 24 lakh; net gain Rs 28 lakh

Explanation

Payout occurs only when the rate exceeds 8%. At 7.6% nil. At 9.2%: 1.2% x 0.25 x 50 crore = Rs 15 lakh. At 10.0%: 2.0% x 0.25 x 50 crore = Rs 25 lakh. Total Rs 40 lakh; net Rs 36 lakh.

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