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CMA Final · Strategic Financial Management · Interest Rate Derivatives

Mahalaxmi Ltd has a ₹10 crore floating-rate loan with annual interest at the reference rate. It buys a cap at 8% and sells a floor at 6% on ₹10 crore, forming a zero-cost collar. At the annual reset the reference rate turns out to be 5%. What is the total interest cost for the year after the collar payoff?

The total interest cost is ₹60,00,000. When the reference rate falls below the 6% floor sold by the borrower, it pays the shortfall of 1%, or ₹10 lakh, on top of the ₹50 lakh loan interest. The collar therefore sets the effective floor on cost at 6%.

  1. A₹60,00,000Correct
  2. B₹50,00,000
  3. C₹70,00,000
  4. D₹80,00,000

Explanation

Loan interest at 5% is ₹50,00,000. The cap is out of the money, so there is no receipt. Because Mahalaxmi sold the floor at 6%, it must pay (6% − 5%) × 10 crore = ₹10,00,000. Total cost = ₹60,00,000, which is the floor rate of 6%. ₹50,00,000 ignores the floor obligation. ₹70,00,000 wrongly adds the payment twice.

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