A manufacturer of electronic components has taken floating interest rate loan of 2 Crore on 1 st April, 2023. The rate of interest at the inception…

CA Final · Advanced Financial Management · PYQS · May 2024
A manufacturer of electronic components has taken floating interest rate loan of 2 Crore on 1 st April, 2023. The rate of interest at the inception of loan is 9% per annum. Interest is to be paid every year on 31 st March. In the month of October 2023, the Central Bank of the country releases the following projections about the interest rates likely to prevail in future. (i) On 31 st March, 2024 – 9.25% On 31 st March, 2025 – 9.50% On 31 st March, 2026 – 10.00% On 31 st March, 2027 – 9.00% On 31 st March, 2028 – 8.25% You are required to show how the borrower can hedge the risk using Option Cap arising out of expected rise in the rate of interest when he wants to peg his interest cost at 9% per annum. (ii) Assume that the premium negotiated by both the parties is 0.80% to be paid at once on 1 st October, 2023 and the actual rate of interest on the respective due dates happens to be as: On 31 st March, 2024 – 9.50% On 31 st March, 2025 – 11.00% On 31 st March, 2026 – 9.25% On 31 st March, 2027 – 9.00% On 31 st March, 2028 – 8.50% You are required to show how the settlement will be executed on the perspective interest due dates. (iii) State whether this option is advantageous when compared to Interest Rate Collar option. Explain.

Suggested Answer and Working Notes:

(i) As borrower does not want to pay more than 9.00% p.a., on this loan where the rate of interest is likely to rise beyond this, hence, he has to hedge the risk by entering into an agreement to buy interest rate caps with the following parameters: Notional Principal:200,00,000/-Strike rate: 9.00% p.a.Reference rate: Rate of interest declared by Central Bank. or the rate of interest applicable to this loan.Calculation and settlement date: 31 st March every yearDuration of the caps: till 31 st March 2028Premium for caps: Negotiable between both the parties To purchase the caps this borrower is required to pay the premium upfront at the time of buying caps. The payment of such premium will entitle him with right to receive the compensation from the seller of the caps as soon as the rate of interest on this loan rises above 9.00%. The compensation will be at the rate of the difference between the rate of none of the cases the cost of this loan will rise above 9.00% calculated on 2,00,00,000. This implies that in none of the cases the cost of this loan will rise above 9.00%. This hedging benefit is received at the respective interest due dates at the cost of premium to be paid only once. (ii) The payment of this premium will entitle the buyer of the caps to receive the compensation from the seller of the caps whereas the buyer will not have obligation. The compensation received by the buyer of caps will be as follows: Date Interest Rate Option Payment of Interest ₹ Settlement / Compensation Amount ₹ Net Interest ₹ 31.03.2024 9.50% Exercise 19,00,000 1,00,000 18,00,000 31.03.2025 11.00% Exercise 22,00,000 4,00,000 18,00,000 31.03.2026 9.25% Exercise 18,50,000 50,000 18,00,000 31.03.2027 9.00% Lapse* 18,00,000 18,00,000 31.03.2028 8.50% Lapse* 17,00,000 17,00,000 * Since actual rate of interest ≤ Strike Rate. Conclusion: From the discussion above it can be said that the overall interest cost for the borrower shall not exceed 9%. (iii) Comparing to Interest Rate Collar, Cap Option appears to be better because even though Collar may not involve initial outflow of cash on account of Premium but selling Put Option at 9% can lead to cash outflow if interest rate goes below 9%.

Topics: Interest Rate Risk Management

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