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CMA Final · Strategic Financial Management · Interest Rate Derivatives

Kaveri Industries wants protection against a rise in its floating borrowing rate above 9%. It buys an interest rate cap with strike 9.00% on ₹8 crore, resetting quarterly. At a reset the reference rate is 10.20% p.a. Ignoring discounting, the payoff for that quarterly period is:

The cap pays ₹2,40,000. The reference rate exceeds the 9% strike by 1.20% per annum, which is 0.30% for a quarter, and 0.30% of ₹8 crore equals ₹2,40,000. Without annualising correctly the payoff would be overstated.

  1. A₹2,40,000Correct
  2. B₹9,60,000
  3. C₹1,20,000
  4. DNil

Explanation

Excess = 10.20% - 9.00% = 1.20% p.a. For one quarter = 0.30%. 0.30% x ₹8 crore = ₹2,40,000. Option 2 applies the full year. Option 4 would apply only if rate were below the strike.

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