XYZ Limited borrows £15 Million of six months SONIA + 10.00% for a period of 24 months. The company anticipates a rise in SONIA, hence it proposes…

First of all we shall calculate premium payable to bank as follows: P = (rp / ((1+i)^t - 1) * (1/i)) * A or P = (rp / PVAF(3.5%,4)) * A Where P = Premium A = Principal Amount rp = Rate of Premium i = Fixed Rate of Interest t = Time = (0.01 / ((1/0.035) - (1 / (0.035×1.035^4)))) × £15,000,000 = (0.01 / (28.571 - (1 / 0.0402))) × £15,000,000 = £40,595 or (£150,000 / 3.671) = £40,861 Now we see the net payment received from bank Reset Period Additional interest due to rise in interest rate Amount received from bank Premium paid to bank* Net Amt. received from bank 1 £75,000 £75,000 £40,861 £34,139 2 £112,500 £112,500 £40,861 £71,639 3 £150,000 £150,000 £40,861 £109,139 TOTAL £337,500 £337,500 £122,583 £214,917 Thus, from above it can be seen that interest rate risk amount of £337,500 reduced by £214,917 by using of Cap option. * Alternatively, if premium paid is considered as £40,595, then above figure of £214,917 shall be changed to £215,715.