DEF Ltd. has implemented a strategy to manage its exposure to fluctuating interest rates by engaging in both interest rate caps and floors. The…

CA Final · Advanced Financial Management · PYQS · May 2025
DEF Ltd. has implemented a strategy to manage its exposure to fluctuating interest rates by engaging in both interest rate caps and floors. The company has purchased $ 50,00,000 (i.e. call options on interest rates) cap of 8% at a premium of 0.75% of the face value to protects against rising interest rates. $ 50,00,000 (i.e. put options on interest rates) floor of 5% is also available at a premium of 0.85% of face value. You are required to analyze the following situation: (i) If Interest rate rise to 10 percent, what is the amount received by DEF Ltd.? What are the net savings from the cap? (ii) If DEF Ltd. also purchases a floor, what are net savings if interest rate rises to 10%? (iii) Calculate net savings if interest rates fall to 4 percent considering cap & floor both purchase. (iv) If DEF Limited has purchases the cap and sell the floor and there is price rise is 11%, what will be net saving to the company?

Suggested Answer and Working Notes:

(i) Premium for purchasing the Cap = 0.0075 × $ 50,00,000 = $ 37,500 If interest rate rises to 10%, Cap purchase receive (10% - 8% = 2%) i.e., $ 50,00,000 × 2/100 = $ 1,00,000, = ($ 1,00,000 - $ 37,500) = $ 62,500 Net saving = $ 62,500 (ii) Purchase Floor, premium for Floor = 0.0085 × $ 50,00,000 = $ 42,500 and Total premium will be $ 37,500 + $ 42,500 = $ 80,000 and = ($ 50,00,000 × 0.02) – $ 80,000 = $ 20,000 Net saving = $ 20,000 (iii) If interest rate falls to 4 percent, there will be no payoff from the Cap, but there will be payoff from Floor. However, the total premium ($ 37,500 + $ 42,500) = $ 80,000 is the cost. Payoff from floor $ 50,00,000 × 0.01 (5% – 4% = 1%) = $ 50,000 = $ 50,000 - $ 80,000 = ($ 30,000) Net loss = ($ 30,000) (iv) Sell the Floor, company will receive 0.0085 × $ 50,00,000 = $ 42,500 and pay premium for Cap 0.0075 × $ 50,00,000 = $ 37,500, net premium receiving will be $ 42,500 – $ 37,500 = $ 5,000 If interest rate rises to 11%, Cap purchase receive = 0.03 × $ 50,00,000 = $ 1,50,000 = $ 1,50,000 + $ 5,000 = $ 1,55,000 Net saving = $ 1,55,000

Topics: Interest Rate Risk Management

Open in Interactive Practice Hub · Full Practice Hub · Chapter Weightage · More in this subject

Related Questions in this Topic