It is now 31 December 2025 and the corporate treasurer of O Ltd. is concerned about the volatility of interest rates. His company needs to…

CA Final · Advanced Financial Management · MTP · November 2026
It is now 31 December 2025 and the corporate treasurer of O Ltd. is concerned about the volatility of interest rates. His company needs to immediately borrow ₹ 2 crore for a six-month period. Current interest rates are 14% per year for the type of loan O Ltd. would use, and the treasurer does not wish to pay more than this. He is considering using either of the following to hedge the interest rate risk: (i) Interest Rate Futures (IRFs), or (ii) An Interest Rate Guarantee The corporate treasurer of O Ltd. expects interest rates to increase by 2% almost immediately and has decided to hedge the interest rate risk using IRFs as per the following details: June Rupee 3-month GOI Treasury Bonds Futures currently priced at 86.25. The standard contract size is ₹ 2,00,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year of the contract size). Required: (i) Demonstrate the results of using the Futures hedge under each of the following three scenarios, if for the entire six-month period: (1) Interest rates increase by 2% and the Futures rates also moves by 2%. (2) Interest rates increase by 2% and the Futures rates moves by 1.5%. (3) Interest rates fall by 1% and the Futures rates moves by 0.75% (ii) As an alternative to Interest Rate Futures, the corporate treasurer has been able to purchase interest rate guarantees at a rate of 14% per annum for a premium of 0.2% of the size of the loan to be guaranteed. Demonstrate whether the total cost of the loan after hedging in each of the three scenarios in (i) above would have been cheaper or more expensive with the futures hedge than with the Interest Rate Guarantee. The guarantee would be effective for the entire six-month period of the loan. Note: Ignore taxation, Margin Requirements, and the Time Value of Money.

Suggested Answer and Working Notes:

(i) Interest rate futures Number of contracts sold = (2,00,00,000 / 2,00,000) × (6 months / 3 months) = 200 contracts The value of one tick is 0.0001 × ₹ 2,00,000 × 3/12 = ₹ 5.00 (1) Interest rates increase by 2% and the Futures rate falls by 2%. ₹ Cash Market Extra interest paid (2% x 6/12 x ₹ 2,00,00,000) (2,00,000) Futures Market On 31 December 2025: Sell 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at (effectively 13.75% per year interest) 86.25 After interest rate increase: Buy 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at (effectively 15.75% per year interest) 84.25 2.00 Total Gain in Ticks per contract (2.00 × 100) = 200 ticks Gain on Futures contracts = 200 contracts x 200 ticks x ₹ 5.00 2,00,000 Overall Net Gain (Loss) on the Strategy = NIL (2) Interest rates increase by 2% and the futures market price falls by 1.5% ₹ Cash Market Extra interest paid (as above) (2,00,000) Futures Market On 31 December 2025: Sell 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at (effectively 13.75% per year interest) 86.25 After interest rate increase: Buy 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at effectively 15.25% per year interest) 84.75 1.50 Total Gain in Ticks per Contract (1.50 x 100) = 150 ticks Gain on Futures contracts = 200 contracts x 150 ticks x ₹ 5.00 = 1,50,000 Overall Net Gain (Loss) on the Strategy (50,000) (3) Interest rates fall by 1% and the futures market price increases by 0.75% ₹ Cash Market Saving of interest (1% × 6/12 × ₹ 2,00,00,000) 1,00,000 Futures Market On 31 December 2025: Sell 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at (effectively 13.75% per year interest) 86.25 After interest rate reduction: Buy 200 ₹ 2,00,000 June GOI Treasury Bonds Futures at effectively 13% per year interest) 87.00 (0.75) Total Loss in Ticks per Contract (0.75 × 100) = 75 ticks Loss on Futures contracts = 200 contracts x 75 ticks x ₹ 5.00 = (75,000) Overall Net Gain on the Strategy ₹ 25,000 Summary: Scenario (1) (2) (3) ₹ ₹ ₹ Cash market interest paid: (16% × 6/12 × ₹ 2,00,00,000) 16,00,000 16,00,000 --- (13% × 6/12 × ₹ 2,00,00,000) --- --- 13,00,000 (Gain)/Loss on Futures Contracts (2,00,000) (1,50,000) 75,000 Overall Cost ₹ 14,00,000 ₹ 14,50,000 ₹ 13,75,000 (ii) Interest rate guarantees The cost (premium) of the guarantee is ₹ 2,00,00,000 × 0.2% = ₹ 40,000, payable whether or not the guarantee is 'exercised'. (1) & (2) Interest rates increase by 2% As interest rates have risen to 16%, the guarantee at 14% will be used i.e. ₹ Cash market cost (14% × 6/12 × ₹ 2,00,00,000) 14,00,000 Premium 40,000 ₹ 14,40,000 This is more expensive than the Futures hedge for (1) and cheaper than for (2). (3) Interest rates fall by 1% As interest rates have fallen to 13%, the guarantee at 14% will not be used i.e. ₹ Cash market cost (13% × 6/12 × ₹ 2,00,00,000) 13,00,000 Premium 40,000 ₹ 13,40,000 This is cheaper than the Futures hedge as the guarantee has allowed the company to take advantage of lower cash market interest rates.

Topics: Interest Rate Risk Management, Derivatives Analysis & Valuation

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