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…

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: 31st March every year.Duration of the caps: till 31st March 2028.Premium 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 200,00,000. 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.