ABC Ltd. has a 100 Crores floating-rate loan, reset annually for 4 years. It enters into a collar strategy to hedge against interest rate risk. Cap…

OR One complete cycle consists of waves made up of two distinct phases, bullish and bearish. On completion of full one cycle i.e. termination of 8 waves movement, the fresh cycle starts with similar impulses arising out of market trading. A zero cost collar results when the premium earned by selling a floor exactly offsets the cap premium. For a zero-cost collar, Value of Cap = Value of Floor. Since volatility is ignored, intrinsic value method is used. Calculation of Cap payoff: Cap pay only when expected rate is > 9.5% Cap payoff in Year 4 = 100 x (10.6% - 9.5%) = 100 x 1.1% ₹ 1.10 crore Total value of Cap = Present value of Cap payoff: PV1.10 x 0.84 = 0.924 crore Calculation of Floor payoff: Floor pays when: Expected Rate < Floor rate From expected rates, floor will apply in Year 1, Year 2 and Year 3 Floor payoff = Notional Value of loan x (F-R) Present Value of Floor payoffs = Year 1: PV1 = 100 (F - 7.8%) × 0.96 Year 2: PV2 =100 (F - 8.6%) × 0.92 Year 3: PV3 = 100 (F - 9.2%) × 0.88 Total Floor value (PV) = 100[(F - 7.8%) x 0.96 + (F - 8.6%) x 0.92 + (F - 9.2%) x 0.88] Applying the zero-cost condition, Cap Value = Floor Value 0.924 = 100[(F-7.8) %) x 0.96 + (F - 8.6) %) x 0.92 + (F - 9.2) %) x0.88] 0.924 = 100 [(0.96F - 7.488) + (0.92F - 7.912) + (0.88F - 8.096)] 0.924 = 100 [2.76F - 23.496)] 0.00924 = 2.76F - 23.496 F = 23.50524/2.76 = 8.516% or say 8.5% Floor rate for zero-cost collar ≈ 8.5% (approx.) or 8.85%* * If % sign is considered along with variables of right-hand side of equation.