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CMA Final · Strategic Financial Management · Interest Rate Derivatives

Sagar Infra buys a 3-quarter interest rate cap on Rs 20 crore at a strike of 8% p.a., paying an upfront premium of Rs 3,00,000. The caplets reset quarterly, with reference rates of 8.4%, 7.6% and 9.2% p.a. for the three quarters. Each caplet pays N x max(rate - strike, 0) x 0.25 at its period end. Ignoring time value, what is the net gain from the cap after the premium?

The net gain is Rs 5,00,000. Each caplet pays separately: Rs 2,00,000 and Rs 6,00,000 for the first and third quarters, nothing for the second. The total of Rs 8,00,000 less the Rs 3,00,000 premium leaves Rs 5,00,000. Negative periods cannot offset gains.

  1. ARs 5,00,000Correct
  2. BRs 8,00,000
  3. CRs 3,00,000
  4. DRs 11,00,000

Explanation

Caplet 1 = 20 crore x 0.4% x 0.25 = Rs 2,00,000. Caplet 2 = nil, as 7.6% is below 8%. Caplet 3 = 20 crore x 1.2% x 0.25 = Rs 6,00,000. Total payoff Rs 8,00,000, less premium Rs 3,00,000 = Rs 5,00,000. Rs 3,00,000 comes from wrongly netting the average rate (8.4%) over all periods, and Rs 8,00,000 ignores the premium.

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