ADVANCED FINANCIAL MANAGEMENT CA.

DINESH JAIN
Chapter 12 – Interest rate risk Management

1. How interest rates are determined?

• Supply and Demand of money: When economic growth is high, demand for money increases,
pushing the interest rates up and vice versa.
• Inflation: The higher the inflation rate, the more interest rates are likely to rise.
• Government: Government is the biggest borrower. The level of borrowing also determines the
interest rates. Central bank i.e. RBI by either printing more notes or through its Open Market
Operations (OMO) changes the key rates (CRR, SLR and bank rates) depending on the state of the
economy or to combat inflation.

2. Explain the concept of Benchmark Rates?

• Benchmark interest is an interest rate that forms the basis for determination of other interest rates.
These rates are also known as ‘Reference Rates’
• It is crucial in economic and banking systems, particularly in financial transactions. These rates are
used in derivative transactions, floating rate loans, and are determined by an independent body.
Benchmark rates are used in both domestic and international financial transactions.
• Popular Benchmark Rates: LIBOR was the popular benchmark rate. LIBOR (London Interbank
Offered Rate), a popular benchmark rate in the international financial market, was discontinued in
2017 due to bank manipulations. Starting January 1, 2022, companies must use Alternative Reference
Rates (ARRs) for contracts. ARRs are based on secured or unsecured overnight transactions, while
LIBOR is unsecured and relies on panel bank judgment. ARRs are considered risk-free with no
term premium.
• Different ARR’s are Secured Overnight Financing Rate (SOFR in USA), Sterling Overnight Index
Average (SONIA in USA), Euro-Short-Term Rate (€STER in Europe), Tokyo Overnight Average Rate
(TONAR in Japan) and Swiss Average Rate Overnight (SARON in Switzerland)
• India Benchmark Rates: India has various benchmark interest rates, including Repo Rate, Prime
Lending Rate, and MCLR. MIBOR (Mumbai Inter Bank Offered Rate and MIBID (Mumbai
Interbank Bid Rate) are the most common, used in derivative deals like Interest Rate Swaps,
Forward Rate Agreements, and Floating Rate Debentures. These rates also form the basis for
valuation of financial instruments like bonds and debentures.

3. What are the different types of interest rate risk?

Gap Exposure ❖ A gap or mismatch risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or re-
pricing dates, thereby creating exposure to unexpected changes in the level of
market interest rates. This exposure is more important in relation to banking
business
❖ Positive Gap indicates that banks have more interest Rate Sensitive Assets
(RSAs) than interest Rate Sensitive Liabilities (RSLs)
❖ Negative gap indicates that banks have more RSLs than RSAs
Basis Risk ❖ The risk that the interest rate of different assets, liabilities and off-balance
sheet items may change in different magnitude is termed as basis risk. For
example, while assets may be benchmarked to Fixed Rate of Interest,
liabilities may be benchmarked to floating rate of interest. The degree of basis
risk is fairly high in respect of banks that create composite assets out of
composite liabilities.
❖ When the variation in market interest rate causes the Net Interest Income
(NII) to expand, the banks have experienced favourable basis shifts and if the
interest rate movement causes the NII to contract, the basis has moved against
the banks
Embedded ❖ Significant changes in market interest rates create another source of risk to
Option Risk banks’ profitability by encouraging prepayment of cash credit/demand
loans/term loans and exercise of call/put options on bonds/debentures
and/or premature withdrawal of term deposits before their stated maturities.
❖ The faster and higher the magnitude of changes in interest rate, the greater
will be the embedded option risk to the banks’ NII.

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Yield Curve ❖ In a floating interest rate scenario, banks may price their assets and liabilities
Risk based on different benchmarks, i.e. TBs yields, fixed deposit rates, call money
rates, MIBOR, etc.
❖ In case the banks use two different instruments maturing at different time
horizon for pricing their assets and liabilities, any non-parallel movements in
yield curves would affect the NII
Price Risk ❖ Price risk occurs when assets are sold before their stated maturities. In the
financial market, bond prices and yields are inversely related. The price risk is
closely associated with the trading book, which is created for making profit out
of short-term movements in interest rates
Reinvestment ❖ Uncertainty with regard to interest rate at which the future cash flows could
Risk be reinvested is called reinvestment risk. Any mismatches in cash flows
would expose the banks to variations in NII as the market interest rates move
in different directions
Net Interest ❖ The size of non-paying liabilities is one of the significant factors contributing
Position Risk towards profitability of banks. Where banks have more earning assets than
paying liabilities, interest rate risk arises when the market interest rates adjust
downwards

4. What are the various methods to hedge interest rate risk?

Traditional Asset and Liability Management (ALM):
Methods ❖ ALM is one of the important tools of risk management in commercial banks of
India
❖ ALM is a comprehensive and dynamic framework for measuring, monitoring
and managing the market risk of a bank. It is the management of structure of
balance sheet (liabilities and assets) in such a way that the net earnings from
interest are maximized within the overall risk preference (present and future) of
the institutions.
❖ The ALM functions extend to liquidly risk management, management of market
risk, trading risk management, funding and capital planning and profit planning
and growth projection

Forward Rate Agreements (FRA):

❖ Forward Rate Agreement (FRA) is an agreement between two parties through
which a borrower/ lender protects itself from the unfavourable changes to the
interest rate
❖ It is used by banks to fix interest costs on anticipated future deposits or interest
revenues on variable-rate loans indexed to LIBOR
❖ It is an off-Balance Sheet instrument
❖ It does not involve any transfer of principal. The principal amount of the
agreement is termed "notional" because, while it determines the amount of the
payment, actual exchange of the principal never takes place
❖ It is settled at maturity in cash representing the profit or loss
❖ The differential amount is discounted at post change (actual) interest rate as it is
settled in the beginning of the period not at the end
Modern Interest Rate Futures (IRF):
Methods ❖ An interest rate future is a contract between the buyer and seller agreeing to the
future delivery of any interest-bearing asset. The interest rate future allows the
buyer and seller to lock in the price of the interest-bearing asset for a future date
❖ A borrower will enter to sell a future today. Then if interest rates rise in the future,
the value of the future will fall (as it is linked to the underlying asset, bond prices),
and hence a profit can be made when closing out of the future (i.e. buying the
future

Interest Rate Options (IRO):

❖ Interest rate options (Interest Rate Guarantee (IRG)) is a right not an obligation
and acts as insurance by allowing businesses to protect themselves against

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adverse interest rate movements while allowing them to benefit from favourable
movements.
❖ It should be noted that the IRO is basically a series of FRAs which are
exercisable at predetermined bench marked interest rates on each period say 3
months, 6 months etc.
❖ Some of the important types of Interest Rate Options are cap option, floor option
and collar option

Interest Rate Swaps (IRS):

❖ In an interest rate swap, the parties to the agreement, termed the swap
counterparties, agree to exchange payments indexed to two different interest
rates. Total payments are determined by the specified notional principal amount
of the swap, which is never actually exchanged

5. What are the types of interest rate swaps?

Plain Vanilla ❖ This is also called as Generic Swap and it involves the exchange of a fixed rate
Swap loan to a floating rate loan.
❖ Floating rate basis can be LIBOR, MIBOR, Prime Lending Rate etc
Basis Rate ❖ This is also called as Non-Generic Swap. Similar to plain vanilla swap with the
Swap difference payments based on the difference between two different variable
rates. For example, one rate may be 1-month LIBOR and other may be 3-month
LIBOR.
❖ Two legs of swap are floating but measured against different benchmarks
Asset Swap ❖ Like plain vanilla swaps with the difference that it is the exchange fixed rate
investments such as bonds which pay a guaranteed coupon rate with floating
rate investments such as an index
Amortising ❖ An interest rate swap in which the notional principal for the interest payments
Swap declines during the life of the swap.
❖ They are particularly useful for borrowers who have issued redeemable bonds
or debentures

6. What are swaptions and explain its types?

❖ An interest rate swaption is simply an option on an interest rate swap. It gives the holder the right but
not the obligation to enter into an interest rate swap at a specific date in the future, at a particular fixed
rate and for a specified term. Example: A 3-month into 5-year swaption would therefore be seen as an
option to enter into a 5-year IRS, 3 months from now.
❖ Following are the two types of swaption contracts:
o A fixed rate payer swaption gives the owner of the swaption the right but not the obligation to
enter into a swap where they pay the fixed leg and receive the floating leg
o A fixed rate receiver swaption gives the owner of the swaption the right but not the obligation
to enter into a swap in which they will receive the fixed leg, and pay the floating leg
❖ Following are the uses of swaptions:
o Swaptions can be applied in a variety of ways for both active traders as well as for corporate
treasurers
o Swap traders can use them for speculation purposes or to hedge a portion of their swap books.
o Swaptions have become useful tools for hedging embedded optionality which is common to the
natural course of many businesses.
o Swaptions are useful to borrowers targeting an acceptable borrowing rate.
o Swaptions are also useful to those businesses tendering for contracts.
o Swaptions also provide protection on callable/puttable bond issues

7. What do you mean by the term ‘Cheapest to Deliver’ in context of Interest Rate Futures? (May
2020 MTP)
❖ All the deliverable bonds have different maturities and coupon rates. To make them comparable to each
other, and also with the notional bond, RBI introduced Conversion Factor. Conversion factor for each
deliverable bond and for each expiry at the time of introduction of the contract is being published by
NSE. (Conversion Factor) x (futures price) = actual delivery price for a given deliverable bond

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❖ The CTD is the bond that minimizes difference between the quoted Spot Price of bond and the Futures
Settlement Price (adjusted by the conversion factor). It is called CTD bond because it is the least
expensive bond in the basket of deliverable bonds.
❖ CTD bond is determined by the difference between cost of acquiring the bonds for delivery and the
price received by delivering the acquired bond. This difference gives the profit / loss of the seller of the
futures.
❖ Profit of seller of futures = (Futures Settlement Price x Conversion factor) – Quoted Spot Price of
Deliverable Bond
❖ Loss of Seller of futures = Quoted Spot Price of deliverable bond – (Futures Settlement Price x Conversion
factor)
❖ That bond is chosen as CTD bond which either maximizes the profit or minimizes the loss.

8. Explain default risk and re-investment risk? [May 2021 MTP]

Re-investment risk:
• This risk is again akin to all those securities, which generate intermittent cash flows in the form of
periodic coupons. The most prevalent tool deployed to measure returns over a period of time is the
Yield-to-Maturity (YTM) method. The YTM calculation assumes that the cash flows generated
during the life of a security is reinvested at the rate of YTM. The risk here is that the rate at which
the interim cash flows are reinvested may fall thereby affecting the returns.
• Thus, reinvestment risk is the risk that future coupons from a bond will not be reinvested at the
prevailing interest rate when the bond was initially purchased.

Default Risk:
• The event in which companies or individuals will be unable to make the required payments on
their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of
credit extensions.
• To mitigate the impact of default risk, lenders often charge rates of return that correspond the
debtor's level of default risk. The higher the risk, the higher the required return, and vice versa. This
type of risk in the context of a Government security is always zero.
Theory to solve problems

Interest rate options:

Interest ❖ Buyer of an interest rate cap pays the seller a premium for the right to receive the
rate caps difference in the interest cost on some notional principal amount if the market
interest rate goes above a stipulated “cap” rate
❖ Cap resembles an option that it represents a right rather than an obligation to the
buyer
Interest ❖ A derivative instrument which protects the buyer of the floor from losses arising
rate floors from decrease in interest rates
❖ The seller of the floor compensates the buyer with a payoff when the interest rate
falls below the strike rate of the floor
Interest ❖ Buyer of an interest rate collar purchases an interest rate cap while selling a floor
rate collars indexed to the same interest rate
❖ Collar = Cap + Floor. This enables the borrower to restrict the maximum interest
outflow. However the buyer cannot benefit from significant fall in interest rates as
the minimum floor rate is to be paid
❖ Collar versus Cap: Cap and collar both restrict the maximum interest outflow.
However the minimum interest outflow is restricted in case of collar. However
investor may prefer buying a collar due to lower premium outflow as compared to
a cap
Note: Option Premium for every reset period is calculated using the below formula:
R  iu
 Nil u
FFid   is, Nu  ids

Forward Rate Agreement (FRA):

❖ A forward rate agreement involves entering into an agreement with the bank under which the bank
will give loan at a specified interest rate on a specified future date

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❖ When a bank quotes a FRA it will give the rate at which it will borrow money and the rate at which
it will lend money
❖ Example: Bank quotes FRA at 4%-5%. This would mean that the bank will pay 4 percent interest in
future and will receive 5 percent interest in case it lends money
❖ 3 X 9 FRA means a customer has entered into an agreement that he would borrow/lend money after
3 months for month 4 to month 9 (6 months)
❖ FRA is settled on net-basis. A bank which sells an FRA agrees to pay the buyer the increased interest
cost on some notional principal amount if some specified maturity of LIBOR is above stipulated
forward rate on the settlement date. Conversely the buyer agrees to pay the seller any decrease in
interest cost if market interest rates fall below the forward rate
❖ The net settlement of FRA is calculated using the below formula:
Ds
Nil iil  ul R − FR R     
  
 + ul R
❖ The differential interest amount in the FRA is discounted at actual interest rate as the FRA is settled
in the beginning of the period and not at the end.

FRA versus Interest rate Futures:

❖ FRA is an OTC derivative instrument whereas the interest rate futures is traded in the exchange.
Bothe instruments helps in fixing the interest rate for a future period
❖ Interest rate futures are quoted as 100 – Interest rate. Hence interest rate futures quote of 94 would
mean that the future interest rate is 6%
u  ig Dui  L
N  s = 
 siz Dui  Fuus

Interest rate / currency swaps:

• An interest rate swap is an agreement between two parties who exchange interest payments based
on a notional principal amount, over an agreed period of time.

Pre-requisites for a swap transaction:

• One party should be stronger than the other. This would mean that it enjoys lower borrowing rates
than the other.
• The two parties should have opposite views about the direction of the movement of the interest rates.

Steps in effective swap:

• Step 1: Identify the rates – This involves tabulating the rates applicable to the two companies.
• Step 2: Compute the net differential
o Difference in fixed rates
o Difference in floating rates
o Net differential
• Step 3: Split the net differential between two companies
• Step 4: Identify the sequence of operations.
S.No STRONGER Company wants floating rate STRONGER Company wants a fixed rate
Operations from view point of strong company
1. Pays bank at fixed rate Pays bank at floating rate
2. Receives from counter party fixed rate as per Receives from counter party floating rate as per
sequence 1 plus strong company’s share of gain sequence A plus strong company’s share of
gain
3 Pays counter party the floating rate which strong Pays counterparty the fixed rate which strong is
company is entitled to from the market entitled to from the market
4 Aggregate after correctly considering the signs. Aggregate after correctly considering the signs.
This will be STRONG Company’s revised This will be STRONG company’s revised fixed
floating rate. rate
Operations from view point of weaker company
5 Pays bank at floating rate Pays bank at fixed rate
6 Pays the fixed rate identified in sequence 2 above Pays the floating rate identified in sequence 2
to the counter party above to the counter party

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7 Receives the floating rate identified in sequence Receives the fixed rate identified in sequence 3
3 above from the counter party above from the counter party
8 Aggregate after correctly considering the signs. Aggregate after correctly considering the signs.
This will be WEAK’s revised fixed rate This will be WEAK’s revised floating rate

Conventions for calculation of interest:

Interest on a money market instrument is paid on March 31 and September 30. Interest for the period April
1 to June 20 is to be calculated under the following conventions.
Conventions Numerator days Denominator days
30/360 basis April and May will be taken as 30 days Denominator will be taken as 180
irrespective of the number of days. Hence the (360/2)
numerator will be taken as 79 days (19 clean
days in June)
Actual days/ 360 April = 30 days ; May = 31 days; June = 19 days Denominator will be taken as 180
Denominator = 80 days (360/2)
Actual days/ April = 30 days; May = 31 days; June = 19 days. April = 30 days; May = 31 days; June
reference period Denominator = 80 days = 30 days; July = 31 days; August =
31 days; September = 30 days
Denominator = 183 days

Practical Problems
Overview:
• Part I – Interest rate futures and options
• Part II – Forward Rate Agreements
• Part III – Interest Rate Swaps

Part I – Interest rate futures and options

1. Interest rate caps and floors [May 2013 RTP, May 2014 MTP]
Suppose that a 1-year cap has a cap rate of 8% and a notional amount of Rs.100 Crores. The frequency of
settlement is quarterly and the reference rate is 3-months MIBOR. Assume that 3-month MIBOR for the next
four quarters is shown below:
Quarters 3-months MIBOR
1 8.70
2 8.00
3 7.80
4 8.20
You are required to compute payoff for each quarter
Answer:
• Cap option restricts the maximum interest outflow and will be exercised if the actual interest rate is
higher than strike rate
Quarter Interest rate Exercise Pay-off
1 8.70 Yes 17,50,000
(100,00,00,000 x 0.70% x 3/12)
2 8.00 No 0
3 7.80 No 0
4 8.20 Yes 5,00,000
(100,00,00,000 x 0.20% x 3/12)

2. Interest rate caps and floors [May 2013 RTP]

Suppose that a 1-year floor has a floor rate of 4% and a notional amount of Rs.100 Crores. The frequency of
settlement is quarterly and the reference rate is 3-months MIBOR. Assume that 3-month MIBOR for the next
four quarters is shown below:
Quarters 3-months MIBOR
1 4.70
2 4.40
3 3.80
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4 3.40
You are required to compute payoff for each quarter
Answer:
• Floor option provided for minimum interest inflow and will be exercised if the actual interest rate is
lower than the strike rate
Quarter Interest rate Exercise Pay-off
1 4.70 No 0
2 4.40 No 0
3 3.80 Yes 5,00,000
(100,00,00,000 x 0.20% x 3/12)
4 3.40 Yes 15,00,000
(100,00,00,000 x 0.60% x 3/12)

3. Interest rate caps and floors [May 2014 RTP, Nov 2018 MTP, May 2019 RTP]
XYZ Limited issues a GBP 10 million floating rate loan on July 1, 2013 with resetting of coupon rate every 6
months equal to LIBOR + 0.50%. XYZ is interested in a collar strategy by selling a floor and buying a cap.
XYZ buys 3 years cap and sell 3 years floor as per the following details on July 1, 2013.
❖ Notional principal amount : GBP 10 million
❖ Reference rate : 6 months LIBOR
❖ Strike rate : 4% for floor and 7% for cap
❖ Premium : 0 as premium paid on cap is
compensated by premium receive on floor

Using the following data you are required to determine:

❖ Effective interest paid out at each reset date
❖ The average overall effective rate of interest
Reset Date LIBOR (%)
31-12-2013 6.00
30-06-2014 7.00
31-12-2014 5.00
30-06-2015 3.75
31-12-2015 3.25
30-06-2016 4.25
Answer:
• Buying a cap will restrict maximum interest outflow and selling a floor will provide for minimum
interest inflow.
• Collar strategy will ensure that interest outflow for all reset periods will be between 4 to 7%
Interest outflow for every reset period:
Reset date No of days LIBOR Int outflow Cap receipt Floor payment Total cost
31-Dec-13 184 6.00 3,27,671 0 0 3,27,671
30-Jun-14 181 7.00 3,71,918 0 0 3,71,918
31-Dec-14 184 5.00 2,77,260 0 0 2,77,260
30-Jun-15 181 3.75 2,10,753 0 12,397 2,23,150
31-Dec-15 184 3.25 1,88,525 0 37,705 2,26,230
30-Jun-16 182 4.25 2,36,202 0 0 2,36,202
Total 1,096 16,62,431
Note:
• No of days = Current reset date – Earlier reset date. For example ,184 days for December 31, 2013 is
time gap between June 30, 2013 and December 31, 2013
• Interest outflow = 1,00,00,000 x (LIBOR + 0.50%) x (No of days/365 or 366). For last two reset periods
denominator will be taken as 366 as the same is of leap year
• Cap receipt is applicable when LIBOR exceed 7%.
• Floor payment is applicable when LIBOR is below 4%. This is breached for June 2015 and we will
have floor payment as 1,00,00,000 x 0.25% x (181/365). Additionally it was breached in December
2015 and we will have floor payment as 1,00,00,000 x 0.75% x (184/366)

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• Total cost = Interest outflow – cap receipt + Floor Payment

Computation of overall effective rate of interest:

,, 
vll iv   is =       = .%
,,, ,

4. Interest Rate Collar [May 2022]

XYZ Limited issues a Rs.50 million floating rate loan on July 1, 2018 with resetting of coupon rate every 6
months equal to LIBOR + 0.50%. XYZ is interested in a collar strategy by selling a floor and buying a cap.
XYZ buys 3 years cap and sell 3 years floor as per the following details on July 1, 2018.
❖ Notional principal amount : Rs.50 Million
❖ Reference rate : 6 months LIBOR
❖ Strike rate : 5% for floor and 8% for cap
❖ Premium : 0 as premium paid on cap is
compensated by premium receive on floor

Using the following data you are required to determine:

❖ Effective interest paid out at each reset date (Round off to nearest rupee)
❖ The average overall effective rate of interest (round off to 2 decimals)
Reset Date LIBOR (%)
31-12-2018 7.00
30-06-2019 8.00
31-12-2019 6.00
30-06-2020 4.75
31-12-2020 4.25
30-06-2021 5.25
Answer:
Interest outflow for every reset period:
Date of No of Floor
Reset date Payment days LIBOR Int outflow Cap receipt payment Total cost
31-Dec-18 30-Jun-19 181 7.00 18,59,589 0 0 18,59,589
30-Jun-19 31-Dec-19 184 8.00 21,42,466 0 0 21,42,466
31-Dec-19 30-Jun-20 182 6.00 16,16,120 0 0 16,16,120
30-Jun-20 31-Dec-20 184 4.75 13,19,672 0 62,842 13,82,514
31-Dec-20 30-Jun-21 181 4.25 11,77,740 0 1,85,959 13,63,699
30-Jun-21 31-Dec-21 184 5.25 14,49,315 0 0 14,49,315
Total 1,096 98,13,703
Note:
• No of days = Date of Payment – Reset Date. For example ,181 days for December 31, 2018 is time gap
between June 30, 2019 and December 31, 2018
• Interest outflow = 5,00,00,000 x (LIBOR + 0.50%) x (No of days/365 or 366). For third and fourth reset
period denominator is taken as 366 due to leap year.
• Floor payment is applicable when LIBOR is below 5%. This is breached for fourth reset period and
fifth reset period
• Total cost = Interest outflow – cap receipt + Floor Payment

Computation of overall effective rate of interest:

,, 
vll iv   is =       = .%
,,, ,
Author’s Note:
• Loan has been taken on July 1, 2018 and hence the first payment should have been on December
31, 2018. However, ICAI solution has assumed the reset rate to be applicable for next six months
and hence the first loan repayment happens on June 30, 2019. This should be technically
considered as incorrect.

5. Caps [Nov 2016 RTP, May 2018 MTP, Nov 2018 MTP, May 2013]

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XYZ Limited borrows £15 Million of six months LIBOR + 10.00% for a period of 24 months. The company
anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the strike rate of 8.00%.
The lumpsum premium is 1.00% for the entire reset periods and the fixed rate of interest is 7.00% per annum.
The actual position of LIBOR during the forthcoming reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap Option. For calculation,
work out figures at each stage up to four decimal points and amount nearest to £. It should be part of
working notes.
Answer:
WN 1: Computation of premium:
Lump-sum Premium = 1,50,00,000 x 1% = GBP 1,50,000
Tl iu ,, ,,
iu  s id = = = = ,
F ,  F .%,  .
Note:
• Premium will be amortized based on the fixed rate of interest. Fixed rate of interest is 7% per annum
and the same will be 3.5% per half-year (reset period). Reset period is taken as six months as the
borrowing is at six-month LIBOR
• Option is for a period of 24 months and hence the same will have 4 reset periods of 6 months

WN 2: Computation of interest outflow:

Period LIBOR Int paid to bank Cap receipt Premium Net Payment

I 9.00% 14,25,000 75,000 40,839 13,90,839

II 9.50% 14,62,500 1,12,500 40,839 13,90,839
III 10.00% 15,00,000 1,50,000 40,839 13,90,839
43,87,500 3,37,500 1,22,517 41,72,517
• Interest paid to Bank = 1,50,00,000 x (LIBOR + 10%) x (6/12)
• Cap receipt is applicable if the LIBOR rate is higher than 8%. LIBOR is higher than 8% for all reset
periods and the difference between 8% and LIBOR is cap receipt
• Net payment = Interest paid to Bank + Premium – Cap receipt
Conclusion:
• The company would have paid extra interest of 3,37,500 (cap receipt) due to increase in interest rates.
However due to cap receipt the interest payout for a reset period does not exceed 18% (LIBOR (8%)
+ 10%). However, in order to save this 3,37,500 the company has pay premium of 1,22,517
• Hence, the company is able to reduce the interest rate risk amount by 2,14,893 by using cap option

6. Collar
a) A company has decided to take a 3 –year floating rate loan of $25 million to finance a project. The
loan is indexed to a 6-month LIBOR with a spread of 100 BP. The current level of LIBOR is 5.75%.
The company thinks that the projected cash flows from the project will enable it to service the loan
as long as the interest cost did not exceed 8.5%. A 3-year interest rate cap with a face value of $25
million and a strike rate of 7% is available for a premium of 3.75 %. Calculate the effective cost of the
capped loan for the following scenario of LIBORs on the next 5 roll-over dates: 5.50%, 6.00%, 6.25%,
6.50% & 6.75(use a rate of 7% to amortize the premium).
b) The above company is offered an interest rate collar with strike rates of 5.75% and 6.5% respectively
for a net premium of 2%. Under this, the company has to compensate the seller of the collar if LIBOR
falls below 5.75%, while the seller compensates the company if LIBOR rises above 6.5%. Compute
the effective cost of the loan under the same scenario?
Answer:
Question No.6A:
WN 1: Computation of Premium:
Lump-sum Premium = 2,50,00,000 x 3.75% = USD 9,37,500

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Tl iu ,, ,,
iu  s id = = = = ,,
F ,  F .%,  .
Note:
• Premium per reset period = 1,75,924.
• Premium per reset period (in %) = (1,75,924/2,50,00,000) x 100 = 0.7037%
• Effective annualized premium = 0.7037 + 0.7037 = 1.41%

WN 2: Computation of effective cost of capped loan:

Reset Period LIBOR Int outflow Cap receipt Premium Total cost
1 5.50 6.50 - 1.41 7.91
2 6.00 7.00 - 1.41 8.41
3 6.25 7.25 -0.25 1.41 8.41
4 6.50 7.50 -0.50 1.41 8.41
5 6.75 7.75 -0.75 1.41 8.41
Note:
• Interest outflow = LIBOR + 1%
• It is assumed that strike rate of 7% is on LIBOR + 1%. Cap receipt is applicable if interest outflow
exceeds 7%
• Interest outflow and cap receipt rate is in terms of per year and hence the premium cost is also
captured for a year
• Total cost = Interest outflow – cap receipt + Premium outflow

Question No.6B:
WN 1: Computation of Premium:
Lump-sum Premium = 2,50,00,000 x 2% = USD 5,00,000
Tl iu ,, ,,
iu  s id = = = = ,
F ,  F .%,  .
Note:
• Premium per reset period = 93,826
• Premium per reset period (in %) = (93,826/2,50,00,000) x 100 = 0.3753%
• Effective annualized premium = 0.3753 + 0.3753 = 0.75%

WN 2: Computation of effective cost of collar loan:

Reset Period LIBOR Int outflow Cap receipt Floor Payment Premium Total cost
1 5.50 6.50 - 0.25 0.75 7.50
2 6.00 7.00 - - 0.75 7.75
3 6.25 7.25 - - 0.75 8.00
4 6.50 7.50 - - 0.75 8.25
5 6.75 7.75 -0.25 - 0.75 8.25
• Strike rate for the option in this part is on LIBOR. This is clearly defined in the question
• Cap receipt will be applicable if LIBOR exceeds 6.50% and floor payment will be applicable if LIBOR
falls below 5.75%

7. Interest rate futures

In two months-time, ABC Limited will receive Rs.3.9 million which it wants to deposit in money market for
three months. ABC Limited at present can deposit at 8% per annum, but the treasurer fears a decrease in
interest rate after two months and hence wishes to hedge using interest rate futures. Three months futures
are currently priced at 93. The standard contract size in the futures market is 0.5 million.
❖ What strategy should the treasurer adopt to hedge the interest rate risk?
❖ If after two months, the futures are priced at 90.75 and interest rate increases to 10.5%, what would
be the effective interest income earned by ABC Limited due to adoption of this strategy?
❖ If after two months, the futures are priced at 94.25 and interest rate falls to 6.5%, what would be the
effective interest income earned by ABC Limited due to adoption of this strategy?
Answer:
Part 1:

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• The company wants to invest Rs.39,00,000 after two months. They can hedge the interest rate risk
through interest rate futures
• No of contracts to be taken = (39,00,000/5,00,000) = 7.8~8 contracts.
• The company will take the interest rate futures which will enable them to invest the money at the
rate of 7% (100 – 93)

Part 2:
Computation of effective interest income:
Net settlement in futures:
Date Position Action Ref date Rate
Day 0 Original Lend Day 60 7%
Day 60 Opposite Borrow Day 60 -9.25%
Loss in % -2.25%
Loss in rupees (5,00,000 x 8 x 2.25% x 3/12) -22,500
• Interest rates have increased in the market and hence the company will earn higher interest income
in spot market. However, part of the gains will be offset by loss in futures position

Effective interest income:

Particulars Calculation Amount
Interest income 39,00,000 x 10.5% x (3/12) 1,02,375
Loss in futures -22,500
Effective interest income 79,875

Part 3:
Computation of effective interest income:
Net settlement in futures:
Date Position Action Ref date Rate
Day 0 Original Lend Day 60 7%
Day 60 Opposite Borrow Day 60 -5.75%
Gain in % 1.25%
Gain in rupees (5,00,000 x 8 x 1.25% x 3/12) 12,500
• Interest rates have declined in the market and hence the company will earn lower interest income in
spot market. However, part of the losses will be offset by gain in futures position

Effective interest income:

Particulars Calculation Amount
Interest income 39,00,000 x 6.5% x (3/12) 63,375
Gain in futures 12,500
Effective interest income 75,875

8. Interest rate futures

The monthly cash budget of ABC Limited shows that the company is likely to need Rs.18 million in two
month’s time for a period of four months. Financial markets have recently been volatile, and the finance
director fears that short term interest rates could rise by as much as 150 ticks (1.5%). LIBOR is currently 6.5%
and ABC can borrow at LIBOR + 0.75%.

The 3 months futures prices (contract size = Rs.5,00,000) are as follows:

❖ December 93.40
❖ March 93.10
❖ June 92.75
Assume that it is now 1 December and that exchange traded futures contracts expire at the end of the month.
You are required to estimate the result of undertaking an interest rate futures hedge if LIBOR increases by
150 ticks (1.5%) and March future increases by 130 ticks (1.3%).
Answer:
• The company plans to borrow Rs.18 million in 2 months for a period of 4 months. The borrowing
period therefore is from Month 2 to Month 6
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• The finance director is worried about the potential increase in interest rates and hence wants to hedge
this through futures market
• Today’s date is December 1 and the borrowing is to be done on January 31. We do not have January
futures and hence the closest available live futures would be March
• The company wants to borrow Rs.18 million for 4 months. Futures interest is computed for 3 months.
Hence the amount to be hedged will be higher than Rs.18 million
• Amount to be hedged = 18 million x (4/3) = Rs.24 million
• Contract size of one futures contract = Rs.0.5 million
• No of contracts = (24/0.5) = 48 contracts
• The company will enter into 48 contracts of Rs.5 lacs each. This will enable the company to borrow
money at 6.90% (100 – 93.10)

Action on maturity date:

• LIBOR has increased by 1.5 percent and hence the company will have to borrow at 8.75% (LIBOR of
8% + 0.75%)
• Interest expense = (180 lacs x 8.75% x (4/12) = Rs.5,25,000
• Net interest expense = 5,25,000 – 78,000 (futures gain) = Rs.4,47,000

, ,  
   =    = . %
, , ,  
Futures settlement:
Date Position Action Ref date Rate
Dec 1 Original Borrow March 31 -6.90%
Jan 31 Opposite Invest March 31 8.20%
Gain in % 1.30%
Gain in rupees (5,00,000 x 48 x 1.30% x 3/12) 78,000
Note: 3-month futures are there in the question and this would mean that interest for futures settlement
would be computed for three-month period.

9. Interest rate hedging [Nov 2017, Nov 2017 RTP]

A textile manufacturer has taken floating interest rate loan of Rs. 40,00,000 on 1st April, 2012. The rate of
interest at the inception of loan is 8.5% p.a. interest is to be paid every year on 31st March, and the duration
of loan is four years. In the month of October 2012, the Central bank of the country releases following
projections about the interest rates likely to prevail in future.
(i) On 31st March, 2013, at 8.75%; on 31st March, 2014 at 10% on 31st March, 2015 at 10.5% and on 31st March,
2016 at 7.75%. Show how this borrowing can hedge the risk arising out of expected rise in the rate of interest
when he wants to peg his interest cost at 8.50% p.a.
(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1st October, 2012 and the
actual rate of interest on the respective due dates happens to be as: on 31st March, 2013 at 10.2%; on 31st
March, 2014 at 11.5%; on 31st March, 2015 at 9.25%; on 31st March, 2016 at 8.25%. Show how the settlement
will be executed on the perspective interest due dates.
Answer:
WN 1: Hedging interest rate risk:
As borrower does not want to pay more than 8.5% p.a., on this loan where the rate of interest is likely to rise
beyond this, hence, he has hedge the risk by entering into an agreement to buy interest rate caps with the
following parameters:
• National Principal : Rs. 40,00,000/
• Strike rate: 8.5% p.a.
• Reference rate : the rate of interest applicable to this loan
• Calculation and settlement date : 31st March every year
• Duration of the caps : till 31st March 2016
• 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 8.5%. 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 8.5% calculated on Rs.

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40,00,000/-. This implies that in none of the cases the cost of this loan will rise above 8.5%. This hedging
benefit is received at the respective interest due dates at the cost of premium to be paid only once.

The premium to be paid on 1st October 2012 is 30,000/- (Rs. 40,00,000 x 0.75/100). The payment of this
premium will entitle the buyer of the caps to receive the compensation from the seller of the caps whereas
the buyer will not have obligation

WN 2: Settlement on respective interest rates:

Date Actual Rate Settlement % Settlement Amount
31 March 2013
st 10.20% 1.70% 68,000
31st March 2014 11.50% 3.00% 1,20,000
31st March 2015 9.25% 0.75% 30,000
31st March 2016 8.25% - -

10. Cheapest to Deliver Bond [May 2021 RTP]

In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying Notional 7.50% Coupon Bonds.
The exchange provides following details of eligible securities that can be delivered:
Security Quoted Price of the Bonds Conversion Factor
7.96 GOI 2023 1037.40 1.0370
6.55 GOI 2025 926.40 0.9060
6.80 GOI 2029 877.50 0.9195
6.85 GOI 2026 972.30 0.9643
8.44 GOI 2027 1146.30 1.1734
8.85 GOI 2028 1201.70 1.2428
Recommend the Security that should be delivered by the XYZ Bank if Future Settlement Price is 1000.
Answer:
• Cheapest to Deliver Bond is one which gives maximum profit to seller of interest rate futures
• Profit = (Futures settlement price x Conversion Factor) – Quoted spot price of bond
Security Spot Conversion Inflow Quoted Price of the Profit
Price Factor (Spot Price x Bonds [Outflow] [Inflow –
Conversion Factor) Outflow]
7.96 GOI 1,000 1.0370 1,037.00 1037.40 -0.40
2023
6.55 GOI 1,000 0.9060 906.00 926.40 -20.40
2025
6.80 GOI 1,000 0.9195 919.50 877.50 42.00
2029
6.85 GOI 1,000 0.9643 964.30 972.30 -8.00
2026
8.44 GOI 1,000 1.1734 1,173.40 1146.30 27.10
2027
8.85 GOI 1,000 1.2428 1,242.80 1201.70 41.10
2028
Since maximum profit to the Bank is in case of 6.80 GOI 2029, same should be opted for

Part II – Forward Rate Agreements

11. Forward Rate Agreements [Nov 2019, May 2018 MTP, Nov 2018 RTP, May 2013]:
P Ltd. is contemplating to borrow an amount of Rs. 50 crores for a period of 3 months in the coming 6 months
time from now. The current rate of interest is 8% per annum but it may go up in 6 months time. The company
wants to hedge itself against the likely increase in interest rate. The Company's Bankers quoted an FRA
(Forward Rate Agreement) at 8.30% per annum.
Compute the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest during
consideration period happens to be (i) 8.60% p.a., or (ii) 7.80% p.a.
(Show your workings on the basis of months)
Answer:
WN 1: Computation of FRA settlement if rate of interest is 8.60% per annum:

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• The company had entered into FRA agreement to borrow at the rate of 8.30%
• The borrowing rate has increased to 8.60% and they will have to borrow at higher rate. However this
would be compensated by FRA settlement of 0.30%

FR Sl  disuig =  s  .%    = Rs. ,,

, , 
     = = . , , 
 + . %
Banker will pay Rs.3,67,107 to P Limited

Net interest outflow if rate is 8.60%:

Particulars Calculation Amount
Interest on loan at 8.60% 50 crores x 8.60% x (3/12) 1,07,50,000
Less: FRA settlement (3,67,107)
Net Amount 1,03,82,893
Effective borrowing rate ,,,  8.31%
      
,,, 
Note: The above computation is not fully logical as FRA settlement happens on day 0 whereas actual interest
is paid after 3 months. However, we have followed this approach as per ICAI solution

WN 2: Computation of FRA Settlement if rate of interest is 7.80% per annum:

• The company had entered into FRA agreement to borrow at the rate of 8.30%
• The borrowing rate has decreased to 7.80% and they will have to borrow at lower rate. However,
rate would increase due to FRA settlement of 0.50%

FR Sl  disuig =  s  .%    = Rs. ,,

, , 
     = = . , , 
 + . %
P Limited will have to pay Rs.6,13,046 to Banker.
Net interest outflow if rate is 8.60%:
Particulars Calculation Amount
Interest on loan at 7.80% 50 crores x 7.80% x (3/12) 97,50,000
Add: FRA settlement 6,13,046
Net Amount 1,03,63,046
Effective borrowing rate ,,,  8.29%
      
,,, 

12. Forward loan arrangement versus FRA

ABC Limited estimates that it would need Rs.50 lacs in two months time for a six month period. The current
6 months money market interest rate is 5.50%-6.00%. But it feels that over the next two months, interest rates
will rise. The other details obtained from the money market are as follows:
Two months 5.25% - 5.75%
Six months 5.5% - 6.00%
Eight months 5.625% - 6.1255%
❖ Explain how ABC Limited could hedge its interest rate exposure by means of forward loan
❖ If ABC Limited wants to enter into an agreement with the bank for FRA, what will be the forward
interest rate that would be quoted by the Bank
❖ If on the date of borrowing the actual interest rate becomes 8%, explain how the FRA will be given
effect?
❖ If on the date of borrowing the actual interest rate becomes 5%, explain how the FRA will be given
effect?
Answer:
Part 1: Forward Loan Arrangement:
• ABC Limited needs Rs.50 lacs from Month 3 to Month 8 (2x8 FRA). The company can hedge its
interest rate exposure through the following steps:
o Borrow money for eight months at 6.1255%
o Invest money for 2 months at 5.25%
o Use money for balance 6 months and repay along with interest

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,, ,,
M   ivsd = = = Rs. ,,
 .
 + .%  

• We need to invest Rs.49,56,629 for 2 months. This will ensure we get Rs.50 lacs in Month 2 and we
can use the same from Month 3 to Month 8. In order to create this deposit, we should borrow
Rs.49,56,629 for a period of 8 months at the rate of 6.1255%


R   s = ,,   + .%   = Rs. ,,

• The above arrangement is effectively a forward loan arrangement where ABC Limited has effectively
taken a loan of Rs.50 lacs in Month 2 and the company has repaid Rs.51,59,041 in Month 8
Particulars Calculation Amount
Interest cost in (Rs.) 51,59,041 – 50,00,000 1,59,041
Interest cost in (%) , ,   6.36%
  
, ,  

Part 2: Forward Rate agreement to be quoted by Bank:

• ABC Limited would want to borrow for a period of 6 months from M2 to M8. This can be done by
asking for 2 x 8 FRA Rate


 + .%  
FF   s  .
FR 2x8 = −= = −
FF   s  .
 + .%  

FR 2x8 = . −  = .  .%   s  .%  u
Note:
• In FRA calculation, if the purpose is to borrow money, then the borrowing rate is to be taken for 8
months and investment rate is to be taken for 2 months
• Similarly, if the purpose is to invest money, then take investment rate for 8 months and borrowing
rate is to be taken for 2 months

Part 3: FRA Settlement if actual rate of interest is 8%:

• ABC Limited will borrow at actual rate of 8% from bank. However, they will get compensation as
part of FRA settlement of 1.64%. This will make the effective borrowing cost as 6.36% (8% - 1.64%)

Part 4: FRA settlement if actual rate of interest is 5%:

• ABC Limited will borrow at actual rate of 5% from bank. However, they will also have to pay 1.36%
as part of FRA settlement. This will make the effective borrowing cost as 6.36% (5% + 1.36%)

13. FRA [May 2018 RTP, May 2010, May 2019 MTP, May 2015 MTP, May 2017 RTP]
The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is 0.25%.
a) What should be 3 months FRA rate at 3 months forward?
b) The 6 & 12 months LIBORS are 5% and 6.5% respectively. A bank is quoting 6/12 USD FRA at 6.50
– 6.75%. Is any arbitrage opportunity available?
Answer:
WN 1: Computation of FRA rate:
• The company wants 3 months FRA rate at 3 months forward. This would technically mean 3x6
FRA

Fuu vlu    s

 FR = −
Fuu vlu    s

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 + . %
  = −  = .  −  = . %    . %  
 + . %

WN 2: Computation of 6X12 FRA rate:

• We have been given 6 months and 12 months rate as 5% and 6.5%. We can use these rates and
calculate 6X12 FRA rate

Fuu vlu    s

 FR = −
Fuu vlu    s

 + . %
  = −  = .  −  = . %    . %  
 + . %

Creation of arbitrage:
• Fair FRA rate for month 6 to 12 is 7.80% per annum. Actual FRA rate is 6.50% - 6.75%.
• Actual FRA indicates that borrowing can be made at 6.75% and deposit can be created at 6.50% for
month 6 to 12
• Actual borrowing rates are lower than Fair FRA rates and hence we should borrow money from
month 6 to 12
• Arbitrage Mechanism:
o Borrow 1,00,000 USD for first 6 months
o Create 1,00,000 USD deposit for 12 months
o Borrow from M6 to M12 using FRA rate

Arbitrage steps:
Particulars Calculation Amount
Day 0
1. Borrow 1,00,000 USD for 6 months @ 5% 1,00,000
2. Create 12-month deposit @ 6.50% 1,00,000
3. Enter into FRA to borrow money from M6 to M12 @
6.75%
Day 180
4. Repay 6-month loan with fresh borrowing @ 6.75% 1,00,000 + (1,00,000 x 5% x 1,02,500
as per FRA 6/12)
Day 365:
5. Maturity value of 12-month deposit 1,00,000 + (1,00,000 x 6.5%) 1,06,500
6. Repay loan along with interest 1,02,500 + (1,02,500 x 6.75% x 1,05,959
6/12)
7. Arbitrage gain 1,06,500 – 1,05,959 541

14. FRA [Nov 2014 RTP, May 2019 RTP]

Two companies ABC Limited and XYZ Limited approach DEF Bank for FRA (Forward Rate Agreement).
They want to borrow Rs.100 Crores after 2 years for a period of 1 year. Bank has calculated yield curve of
both companies as follows:
Year XYZ Limited ABC Limited
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
❖ You are required to calculate the rate of interest DEF Bank would quote under 2v3 FRA, using the
company’s yield information as quoted above
❖ Suppose bank offers Interest rate guarantee for a premium of 0.1% of the amount of loan, you are
required to calculate the interest payable by XYZ Limited if interest in 2 years turns out to be
o 4.50%
o 5.50%
Answer:
WN 1: Computation of FRA rate:

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• The company wants to borrow after 2 years for a period of 1 year. The company therefore is looking
at getting 2x3 FRA rate

XYZ Limited:

Fuu vlu    s  + .%3

FR = −= −  = .%
Fuu vlu    s  + .%2

ABC Limited:
Fuu vlu    s  + .%3
FR = −= −  = .%
Fuu vlu    s  + .%2

WN 2: Computation of actual interest with interest rate guarantee:

• Interest rate guarantee is either a cap or floor option depending on whether we are borrower or
lender
• XYZ Limited is borrower and they would want to restrict the maximum interest outflow
• It is assumed that strike rate of option is equal to fair FRA rate of 5.04%

Actual interest rate is 4.50%

• XYZ Limited will pay 4.50% and their overall cost will be 4.60% including premium

Actual interest rate is 5.50%

• XYZ Limited will pay 5.04% and their overall cost will be 5.14% including premium

15. FRA [May 2014 RTP, May 2018 RTP, Nov 2016 MTP, May 2021 RTP]
Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in nature.
In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6 months
firm cash crunch, leading to borrowing of money to cover up its exposures for running the business. It is
expected that firm shall borrow a sum of €50 million for the entire period of slack season in about 3 months.
A Bank has given the following quotations:
❖ Spot 5.50% - 5.75%
❖ 3 × 6 FRA 5.59% - 5.82%
❖ 3 × 9 FRA 5.64% - 5.94%
3 month €50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85%).
You are required to determine:
❖ How a FRA, shall be useful if the actual interest rate after 6 months turnout to be:
o 4.5%
o 6.5%
❖ How 3 months Future contract shall be useful for company if interest rate turns out as mentioned in
part (a) above.
Answer:
WN 1: Effect of FRA:
• The company wants to borrow after 3 months for entire slack season of 6 months. This would mean
borrowing from M3 to M9.
• The company should enter into 3x9 FRA to hedge interest rate risk
• Relevant 3x9 FRA borrowing rate is 5.94%
Particulars Actual rate of Actual rate of
4.50% 6.50%
1. Payment to original lender 4.50% 6.50%
2. Payment by Electraspace to bank (FRA settlement) 1.44% -
3. Receipt by Electraspace from Bank (FRA settlement) - (0.56%)
4. Net borrowing cost 5.94% 5.94%

WN 2: Hedging through interest rate futures:

• The company wants to borrow 50 million for 6 months. Futures contracts are available only for 3
months and hence we should adjust the value of futures contract
• Borrowing 50 million for 6 months is similar to borrowing 100 million for 3 months

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u   dgd  illi

N  uus s = = = , s
Siz    ,

Actual interest rate is 4.50%

Particulars Calculation Amount
1. Interest to be paid on original loan 50 million x 4.50% x 6/12 11,25,000
2. Futures settlement (Note 1) 3,37,500
3. Total outflow 14,62,500
4. Effective borrowing cost , ,   5.85%
    
  

Note 1: Computation of futures settlement:

Date Position Action Reference Date Rate
Day 0 Original Position Borrow Day 90 5.85%
Day 90 Opposite Position Lend Day 90 4.50%
Loss in % 1.35%
 3,37,500
      . %   


Actual interest rate is 6.50%

Particulars Calculation Amount
1. Interest to be paid on original loan 50 million x 6.50% x 6/12 16,25,000
2. Futures settlement (Note 1) (1,62,500)
3. Total outflow 14,62,500
4. Effective borrowing cost , ,   5.85%
    
  

Note 1: Computation of futures settlement:

Date Position Action Reference Date Rate
Day 0 Original Position Borrow Day 90 5.85%
Day 90 Opposite Position Lend Day 90 6.50%
Profit in % 0.65%
 1,62,500
      . %   


16. Forward rate agreement [Nov 2012 RTP, May 2019 MTP, May 2016 MTP]
TM Fincorp has bought a 6X9 Rs.100 crore Forward Rate Agreement (FRA) at 5.25%. On fixing date reference
rate, MIBOR turns out to be as follows:
Period Rate (%)
3 months 5.50
6 months 5.70
9 months 5.85
You are required to determine:
(a) Profit/Loss to TM Fincorp. In terms of basis points
(b) The settlement amounts
(Assume 360 days in a year)
Answer:
WN 1: Computation of profit/loss in terms of basis points:
❖ The company has taken a 6x9 FRA and hence the borrowing is from month 6 to month 9. We now
have the actual rates for Month 6 and hence the relevant rate is for next 3 months. Therefore, the
actual rate is 5.50%
❖ The company had taken FRA at 5.25% and the actual rate is 5.50%. Hence the company will be
gaining 0.25% due to FRA

WN 2: Computation of profit/loss:
Particulars Calculation Amount
Profit in Forward Rate Agreement 0.25%
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Amount of settlement (undiscounted) 100 crores x 0.25% x (3/12) 6,25,000
,,
Amount of settlement (discounted)  6,16,523
 + .% 


Conclusion: Hence settlement on reference date will have to be done for Rs.6,16,523

17. Forward Rate Agreement [May 2014 MTP]

The treasurer of a company expects to receive a cash inflow of $15,000,000 in 90 days. The treasurer expects
short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the treasurer
decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is quoted at 1.5%. At
expiration, LIBOR is 1.25%. Assume that the notional principal on the contract is $15,000,000.
(i) Indicate whether the treasurer should take a long or short position to hedge interest rate risk.
(ii) Using the appropriate terminology identify the type of FRA used here.
(iii) Calculate the gain or loss to the company as a consequence of entering the FRA
Answer:
i. The company needs to invest money and hence they should take a short position in FRA
ii. The company will receive money after 3 months. The investment is needed for a period of 3
months. Therefore, we should go for 3 x 6 FRA
iii. Computation of settlement:
Particulars Calculation Amount
Profit in Forward Rate Agreement 0.25%
Amount of settlement (undiscounted) 150 lacs x 0.25% x (3/12) 9,375
,
Amount of settlement (discounted)  9,346
 + .%  


Part III – Interest Rate Swaps

18. Mechanism of Interest rate swap

A and B Limited have entered into a three year swap on March 5, 2010 wherein A agrees to pay a fixed rate
of interest of 5 percent per annum and B agrees to pay LIBOR on a notional principal of 100 million USD. The
agreement specifies the payment to be arranged every six months. The floating rate of interest on various
reset dates happened to be as follows:
Date Floating rate
5/3/10 4.2
5/9/10 4.8
5/3/11 5.3
5/9/11 5.5
5/3/12 5.6
5/9/12 5.9
5/3/13 6.4
❖ Calculate the net cash flow to A and B from the swap arrangement
❖ Comment upon A and B regarding their view on interest rates
❖ A Limited has borrowed money at a floating rate of LIBOR + 0.10% and B Limited has borrowed at
fixed rate of 5.2%. A Limited wants to transform its floating rate loan into fixed rate and B Limited
wants to transform its fixed rate to floating rate. Illustrate how swap has been structured and what
is the effective borrowing cost post swap arrangement.
Answer:
WN 1: Computation of net cash flows from swap arrangement:

Net cash
Amount to be Amount to be flows
Date No of days Fixed rate Floating rate paid by A paid by B B to A
05-Sep-10 184 5% 4.80% 25,20,548 24,19,726 -1,00,822
05-Mar-11 181 5% 5.30% 24,79,452 26,28,219 1,48,767
05-Sep-11 184 5% 5.50% 25,13,661 27,65,027 2,51,366

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05-Mar-12 182 5% 5.60% 24,86,339 27,84,699 2,98,360
05-Sep-12 184 5% 5.90% 25,20,548 29,74,247 4,53,699
05-Mar-13 181 5% 6.40% 24,79,452 31,73,699 6,94,247
Note:
• It is assumed that LIBOR on reset dates is applicable for previous six months interest computation.
For example, LIBOR on September 5, 2010 is 4.8 percent and the same was used to calculate interest
from March 5, 2010 to September 5, 2010
• Negative net cash flows will indicate amount payable by A Limited to B Limited

View on interest rates:

• A is willing to pay a fixed rate of 5 percent in return for LIBOR receipt. This would help A Limited
in converting a floating rate loan to a fixed rate loan. A Limited want to pay effective fixed rate and
hence they will have a view of interest rates going up
• B Limited plans to pay effective floating rate and hence they will have a view of interest rate coming
down

WN 2: Computation of effective borrowing rate:

Particulars A Limited B Limited
1. Pay to banker as per original borrowed rate LIBOR + 0.10% 5.20%
2. A Limited to B Limited 5% (5%)
3. B Limited to A Limited (LIBOR) LIBOR
4. Effective borrowing rate 5.10% LIBOR + 0.20%

19. Interest rate swap

Madagascar Limited is an Indian company. They are in the process of raising a US dollar loan and are
negotiating the rates with a foreign bank. The company has been offered a fixed rate of 8 percent with a
proviso that they should opt for a floating rate, the interest rate is likely to be linked to the bench mark rate
of 60 basis points over 10 year US T Bill rate with interest refixation on a three-monthly basis. The
expectations of Madagascar Limited are that the Dollar interest rates will fall and are inclined to have a
flexible mechanism built into their interest rates. On enquiry they find that they could go for a swap
arrangement with Syndicate India Limited who have been offered a floating rate of 120 basis points over 10
year T Bill rate as against a fixed rate of 9.20 percent. Describe the swap on the assumptions that
• The swap differential is shared between the two equally or
• The swap differential is shared between Madagascar and Syndicate in the ratio of 3:1
• The swap banker charges 0.1% as charges and swap benefits are shared equally
Answer:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
M Limited 8% T+0.6%
S Limited 9.2% T+1.2%

• Total interest rate of combination 1 [M limited (fixed) & S Limited (Floating)] = 8% + T + 1.2% =
T+9.2%
• Total interest rate of combination 2 [M limited (floating) & S Limited (fixed)] = T + 0.6% + 9.2% =
T+9.8%
• Ideal combination = Combination 1; This would mean that M Limited should borrow at fixed rate
and S Limited should borrow at floating rate
• Actual scenario: M Limited plans to borrow at floating rate and S Limited plans to borrow at fixed
rate
• Scope for Interest rate swap exist as the ideal and actual scenario does not match
• Swap gain = Difference in total interest of combination 1 & 2 = (T + 9.8%) – (T + 9.2%) = 0.6%
• Share of swap gain (equal gain):
o M Limited = 0.30%
o S Limited = 0.30%

WN 2: IRS structuring:

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Particulars M Limited S Limited
1. Pay to banker as per ideal rate 8% T + 1.2%
2. M Limited to S Limited T (T)
3. S Limited to M Limited (b/f) (7.7%) 7.7%
4. Effective borrowing rate T + 0.3% 8.9%

Notes:
• M Limited wanted to borrow at floating rate. They will be asked to pay Treasury bill rate to S Limited
and this would swap their fixed loan to a floating loan
• Effective borrowing rate = Original rate – share of swap gain
• S Limited payment to M Limited will be taken as balancing figure

WN 3: IRS structuring if gain is shared in the ratio of 3:1

Share of swap gain:
• M Limited = 0.60 x (3/4) = 0.45%
• S Limited = 0.60 x (1/4) = 0.15%

Particulars M Limited S Limited

1. Pay to banker as per ideal rate 8% T + 1.2%
2. M Limited to S Limited T (T)
3. S Limited to M Limited (b/f) (7.85%) 7.85%
4. Effective borrowing rate T + 0.15% 9.05%

WN 4: IRS Structuring with swap intermediary:

Share of swap gain:
• Intermediary = 0.10% (assumed to be combined charge from both companies)
• M Limited = 0.25%
• S Limited = 0.25%

Structuring for M Limited:

Particulars M Limited
1. Pay to banker as per ideal rate 8%
2. M Limited to intermediary T
3. Intermediary to M Limited (bal figure) (7.65%)
4. Effective borrowing rate T + 0.35%

Structuring for S Limited:

Particulars S Limited
1. Pay to banker as per ideal rate T + 1.20%
2. S Limited to intermediary (bal figure) 7.75%
3. Intermediary to S Limited (T)
4. Effective borrowing rate 8.95%

20. Interest rate swap

There are two firms A and B. Firm A has invested USD 100 million in fixed rate bonds yielding 8.5 percent.
Firm A is not a highly rated firm and it has raised its loan for funding its assets through floating rate loan
from bank at an interest rate of LIBOR + 0.50%. Firm B has invested USD 100 million in floating rate bond
yielding LIBOR + 0.75% and it has raised its loan for funding its assets through fixed rate loan from bank at
6%. There is a big bank which offers interest rate swap with a spread of 0.10% as follows:
❖ Swap Bid = 6.4% for LIBOR
❖ Swap Ask = 6.5% for LIBOR
a) Explain how the two companies can reduce the interest rate risk
b) Calculate the companies locked in spread
Answer:
Hedging interest rate risk:

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• Firm A has taken a floating rate loan and created a fixed rate deposit. Firm A will be impacted if
interest rates go up. Firm A should enter into IRS with Big Bank. They should receive LIBOR and
pay 6.5 percent to other party
• Firm B has taken a fixed rate loan and created a floating rate deposit. Firm B will be impacted if
interest rates come down. Firm B should enter into IRS with Big Bank. They should pay LIBOR and
receive 6.4 percent from other party

Computation of locked in spread:

Particulars Firm A Firm B
1. Investment rate 8.5% LIBOR + 0.75%
2. Borrowing Rate (LIBOR + 0.50%) (6%)
3. Firm to Big Bank (6.5%) (LIBOR)
4. Big Bank to Firm LIBOR 6.4%
5. Locked in spread 1.50% 1.15%

21. Interest rate swap [May 2010]

ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + 0.25% for Rs.200
million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six months LIBOR treating six
months as exactly half a year.
❖ What will be the all in cost funds to ABC Bank?
❖ Another instrument being considered is the issue of a hybrid instrument which pays 7.5% for first
three years and LIBOR – 0.25% of remaining two years. Given a three year swap rate of 8%, suggest
the method by which the bank could achieve fixed rate funding.
Answer:
WN 1: Computation of effective borrowing rate:
Particulars Rate
1. Original borrowing rate LIBOR + 0.25%
2. ABC Bank to counterparty 7.5%
3. Counterparty to ABC Bank (LIBOR)
4. Effective borrowing rate 7.75%

WN 2: Hedging for hybrid instrument:

• ABC Bank will pay fixed rate for first three years and floating rate for next two years. They want to
convert into fixed rate loan for all five years
• Five-year swap will not help as it will convert the first three year into floating rate. Three-year swap
will also not help as it will convert first three years into floating rate
• To hedge the hybrid instrument, we need to follow the below steps:
o Use 3-year swap and convert fixed rate into floating rate
o Use 5-year swap and convert entire floating loan into fixed rate loan

Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Original borrowing rate 7.5% 7.5% 7.5% LIBOR – LIBOR –
0.25% 0.25%
3-year swap
Receipt (8%) (8%) (8%)
Payment LIBOR LIBOR LIBOR
Effective cost post 3-year LIBOR – LIBOR – LIBOR – LIBOR – LIBOR –
swap 0.5% 0.5% 0.5% 0.25% 0.25%
5-year swap
Receipt (LIBOR) (LIBOR) (LIBOR) (LIBOR) (LIBOR)
Payment 7.5% 7.5% 7.5% 7.5% 7.5%
Effective cost post 5-year 7% 7% 7% 7.25% 7.25%
swap

22. Interest rate swap

Grades Limited enjoys a high credit rating and is capable of raising term funds either at a fixed rate of 10%
p.a. or at a floating rate of 40 basis points over MIBOR. Level Limited enjoys a relatively lower credit rating

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and is able to borrow either at 80 basis points over MIBOR or at affixed rate of 10.5%. Level limited wants to
borrow at fixed rate whereas Grades would like to enjoy a floating rate. Structure a swap arrangement such
that Grades gains 2/3rd of the total gain. Assume that there are no intermediaries. What action would follow
if Grades apprehends that interest rates will harden while Level believes that interest rates will soften?
Answer:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
Grades Limited 10% MIBOR + 0.40%
Level Limited 10.50% MIBOR + 0.80%

• Total interest rate of combination 1 [Grades limited (fixed) & Level Limited (Floating)] = 10% +
MIBOR + 0.8% = MIBOR + 10.80%
• Total interest rate of combination 2 [Grades limited (floating) & Level Limited (fixed)] = 10.50% +
MIBOR + 0.40% = MIBOR + 10.90%
• Ideal combination = Combination 1; This would mean that Grades Limited should borrow at fixed
rate and Level Limited should borrow at floating rate
• Actual scenario: Grades Limited plans to borrow at floating rate and Level Limited plans to borrow
at fixed rate
• Scope for Interest rate swap exist as the ideal and actual scenario does not match
• Swap gain = Difference in total interest of combination 1 & 2 = 0.10%
• Share of swap gain (2:1):
o Grades Limited = 0.07%
o Level Limited = 0.03%

WN 2: IRS structuring:
Particulars Grades Limited Level Limited
1. Pay to banker as per ideal rate 10% MIBOR + 0.80%
2. Grades Limited to Level Limited MIBOR (MIBOR)
3. Level Limited to Grades Limited (bal figure) (9.67%) 9.67%
4. Effective borrowing rate MIBOR + 0.33% 10.47%

Rework scenario:
• Grades Limited believes that interest rates will harden (go up) and hence they would opt for fixed
rate loan. Level Limited believes that interest rates will soften (come down) and hence they would
opt for floating rate loan
• The above scenario is in line with ideal combination and hence no scope for IRS exist

23. Interest rate swap [May 2019, May 2021 MTP, Nov 2020]
IM is an American firm having its subsidiary in Japan and JI is a Japanese firm having its subsidiary in USA.
They face the following interest rates
Particulars IM JI
USD floating rate LIBOR + 0.5% LIBOR + 2.5%
JPY Fixed rate 4% 4.25%
IM wishes to borrow USD at floating rate and JI JY at fixed rate. The amount required by both the companies
is same at the current exchange rate. A financial institution requires 75 basis points as commission for
arranging swap. The companies agree to share the benefit/loss equally.
You are required to find out
(i) Whether a beneficial swap can be arranged?
(ii) What rate of interest for both IM and JI?
Answer:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
IM 4% LIBOR + 0.50%
JI 4.25% LIBOR + 2.5%

• Total interest rate of combination 1 [IM limited (fixed) & JI Limited (Floating)] = 4% + LIBOR + 2.5%
= LIBOR + 6.5%

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• Total interest rate of combination 2 [IM limited (floating) & JI Limited (fixed)] = LIBOR + 0.5% +
4.25% = LIBOR + 4.75%
• Ideal combination = Combination 2; This would mean that IM Limited should borrow at floating rate
and JI Limited should borrow at fixed rate
• Actual scenario: IM Limited plans to borrow at floating rate and JI Limited plans to borrow at fixed
rate
• Scope for IRS does not exist as the actual scenario is in line with ideal scenario
• Effective borrowing rate for IM = LIBOR + 0.5%
• Effective borrowing rate for JI = 4.25%

Note: ICAI solution to this question is wrong and hence the same has not been followed

24. Interest rate swap:

Electronic Limited enjoys a high rating in Indian money market due to its strong financials and track record.
Tim software Ltd., is a new but a growing company. Electronic and Tim Software Ltd., can obtain loans at
the rate given below:
Particulars CD (company Deposit) with Fixed Mumbai Inter-bank Money Market with
rate Variable rate
Electronic Limited T + 0.50% MIBOR + 0.10%
Tim Software T + 2.10% MIBOR + 0.60%
Limited
*Here T means the risk free 15 years Government Bonds.
Electronic Ltd., wants to take a loan at variable rate, while Tim Software wants to take loan at fixed rate. The
two companies approached a bank to design a suitable Swaps.
(a) If the bank wants to have a profit of 0.20% to be contributed from Tim Software’s (out of total profits of
Swap) share of Swap benefit, what would be the two agreements that the bank will enter with these two
companies.
(b) What are the likely costs of debts to the two companies.
Answer:
WN 1: Identification of interest rate benefit:
Particulars Calculation Amount
Total cost of combination 1 T + 0.50% + MIBOR + 0.60% T + MIBOR + 1.10%
Electronic (Fixed) & Tim (Floating)
Total cost of combination 1 MIBOR + 0.10% + T + 2.10% T + MIBOR + 2.20%
Electronic (Floating) & Tim (Fixed)
❖ Ideal combination as per the above table is combination 1 as the same has lower net cost. Therefore,
Electronic Limited should borrow in fixed and Tim Limited should borrow in Floating rate.
However, the actual borrowing requirement is opposite and hence the opportunity for interest rate
swap exists
❖ Swap will have total gain of 110 bps. The gain will be shared as 55 bps for Electronic Limited and 55
bps for Tim Software Limited. The swap intermediary will charge 20 bps from Tim Software Limited
and hence net gain for Tim software Limited is 35 bps.

WN 2: Structuring of swap arrangement:

Particulars Electronic Tim Software
Limited Limited
Borrow from bank as per ideal combination T + 0.50% MIBOR + 0.60%
Receive from swap intermediary (receive what is paid to (T + 0.50%) (MIBOR + 0.60%)
bank
Pay to swap intermediary (Balancing figure) MIBOR - 0.45% T + 1.75%
Effective cost (Original borrowing cost – swap gain) MIBOR - 0.45% T + 1.75%

25. Interest rate swap [May 2011 RTP]

The following details are related to the borrowing requirements of ABC Limited and DEF Limited.
Company Requirement Fixed rate Floating rate
ABC Limited Fixed rate 4.5% PLR + 2%
DEF Limited Floating rate 5.0% PLR + 3%

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Both companies are in need of Rs.2,50,00,000 for a period of 5 years. The interest rates on the floating rate
loans are reset annually. The current PLR for various maturities are as follows:
Maturity (years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375
DEF Limited has bought an interest rate cap at 5.625% at an upfront premium payment of 0.25%. You are
required to exhibit how these two companies can reduce their borrowing cost by adopting a swap assuming
that gains resulting from swap shall be shared equally among them. Further calculate cost of funding to these
two companies assuming that expectation theory holds good for the 4 years.
Answer:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
ABC Limited 4.5% PLR + 2%
DEF Limited 5.0% PLR + 3%

• Total interest rate of combination 1 [ABC limited (fixed) & DEF Limited (Floating)] = 4.5% + PLR +
3% = PLR + 7.5%
• Total interest rate of combination 2 [ABC limited (floating) & DEF Limited (fixed)] = 5.0% + PLR +
2% = PLR + 7%
• Ideal combination = Combination 2; This would mean that ABC Limited should borrow at floating
rate and DEF Limited should borrow at fixed rate
• Actual scenario: ABC Limited plans to borrow at fixed rate and DEF Limited plans to borrow at
floating rate
• Scope for Interest rate swap exist as the ideal and actual scenario does not match
• Swap gain = Difference in total interest of combination 1 & 2 = 0.50%
• Share of swap gain (1:1):
o ABC Limited = 0.25%
o DEF Limited = 0.25%

WN 2: IRS structuring:
Particulars ABC Limited DEF Limited
1. Pay to banker as per ideal rate PLR + 2% 5%
2. ABC Limited to DEF Limited 2.25% (2.25%)
3. DEF Limited to ABC Limited (PLR) PLR
4. Effective borrowing rate 4.25% PLR + 2.75%

WN 3: Computation of effective borrowing rate:

ABC Limited:
• ABC Limited has effective fixed rate funding and hence their effective cost will be 4.25%

DEF Limited:
Part 1: Computation of forward interest rates:
FRA Formula Calculation Rate
1 to 2 FF   s  + %2 3.25%
− −
FF     + .%1
3
2 to 3 FF   s  + .% 3.60%
− −
FF   s  + %2
3 to 4 FF   s  + .%4 3.60%
− −
FF   s  + .%3
4 to 5 FF   s  + .% 5
3.68%
− −
FF   s  + .%4

Part 2: Effective borrowing cost:

Year Forward Rate Borrowing cost Cap receipt@ Net borrowing cost
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(PLR + 2.75%)
1 2.75% 5.50% 0 5.50%
2 3.25% 6.00% (0.375%) 5.625%
3 3.60% 6.35% (0.725%) 5.625%
4 3.60% 6.35% (0.725%) 5.625%
5 3.68% 6.43% (0.805%) 5.625%
Effective borrowing rate# 5.60%
@ It is assumed that strike rate given in the question is for DEF’s borrowing rate (PLR + 2.75%)
# Effective borrowing cost excludes premium on interest rate cap

26. Interest rate swap [Nov 2016 RTP, Nov 2018, Nov 2008, Nov 2010, May 2021 MTP]
Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six months LIBOR flat. If the notion
principal amount of swap is Rs.5,00,000.
• Calculate semi-annual fixed payment
• Find the first floating rate payment for above if the six month period from the effective date of swap
to the settlement date comprise of 181 days and that the corresponding LIBOR was 6% on the
effective date of swap
• In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would pay to the
floating rate payer? Generic swap is based on 30/360 days basis.
Answer:

Si − ul id  = ,,  %    = ,


Flig  = ,,  %    = ,

N   id    lig   = , − , = Rs. ,

27. Evaluation of interest swap arrangement [Nov 2015 RTP]

NoBank offers a variety of services to both individuals as well as corporate customers. NoBank generates
funds for lending by accepting deposits from customers who are paid interest at PLR which keeps on
changing.

NoBank is also in the business of acting as intermediary for interest rate swaps. Since it is difficult to identify
matching client, NoBank acts counterparty to any party of swap. Sleepless approaches NoBank who
already have Rs. 50 crore outstanding and paying interest @PLR+80bp p.a. The duration of loan left is 4
years. Since Sleepless is expecting increase in PLR in coming year, he asked NoBank for arrangement of
interest of interest rate swap that will give a fixed rate of interest.

As per the terms of agreement of swap NoBank will borrow Rs.50 crore from Sleepless at PLR+80bp per
annuam and will lend Rs. 50 crore to Sleepless at fixed rate of 10% p.a. The settlement shall be made at the
net amount due from each other. For this services NoBank will charge commission @0.2% p.a. if the loan
amount. The present PLR is 8.2%.

You as a financial consultant of NoBank have been asked to carry out scenario analysis of this arrangement.
Three possible scenarios of interest rates expected to remain in coming 4 years are as follows:
Year 1 Year 2 Year 3 Year 4
Scenario 1 10.25 10.50 10.75 11.00
Scenario 2 8.75 8.85 8.85 8.85
Scenario 3 7.20 7.40 7.60 7.70
Assuming that cost of capital is 10%, whether this arrangement should be accepted or not.
Answer:
WN 1: Computation of NPV of scenario 1:
Payment by Receipt by
Nobank nobank Net payment/
Year PLR PLR + 0.80% 10.20% receipt PVF @ 10% DCF
1 10.25% 5,52,50,000 5,10,00,000 (42,50,000) 0.909 (38,63,250)
2 10.50% 5,65,00,000 5,10,00,000 (55,00,000) 0.826 (45,43,000)
3 10.75% 5,77,50,000 5,10,00,000 (67,50,000) 0.751 (50,69,250)

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4 11.00% 5,90,00,000 5,10,00,000 (80,00,000) 0.683 (54,64,000)
NPV of scenario 1 (1,89,39,500)

WN 2: Computation of NPV of scenario 2:

Payment by Receipt by
Nobank nobank Net payment/
Year PLR PLR + 0.80% 10.20% receipt PVF @ 10% DCF
1 8.75% 4,77,50,000 5,10,00,000 32,50,000 0.909 29,54,250
2 8.85% 4,82,50,000 5,10,00,000 27,50,000 0.826 22,71,500
3 8.85% 4,82,50,000 5,10,00,000 27,50,000 0.751 20,65,250
4 8.85% 4,82,50,000 5,10,00,000 27,50,000 0.683 18,78,250
NPV of scenario 2 91,69,250

WN 3: Computation of NPV of scenario 3:

Payment by Receipt by
Nobank nobank Net payment/
Year PLR PLR + 0.80% 10.20% receipt PVF @ 10% DCF
1 7.20% 4,00,00,000 5,10,00,000 1,10,00,000 0.909 99,99,000
2 7.40% 4,10,00,000 5,10,00,000 1,00,00,000 0.826 82,60,000
3 7.60% 4,20,00,000 5,10,00,000 90,00,000 0.751 67,59,000
4 7.70% 4,25,00,000 5,10,00,000 85,00,000 0.683 58,05,500
NPV of scenario 3 3,08,23,500
Conclusion:
• Nobank should go ahead with IRS if they believe Scenario 2/3 is likely scenario. However, if they
believe scenario 1 will happen they should avoid IRS

28. Calculation of interest expenditure:

Principal USD 100 million
Interest 8% p.a.
Coupon March 1 and September 1
Calculate interest from March 1 to July 3 under following day count conventions:
❖ 30/360 (coupon bonds)
❖ Actual days / 360 (money market instruments)
❖ Actual days / reference period days (treasury days)
Answer:
Computation of interest:
Convention Numerator Denominator Calculation Amount
30/360 122 days 180 days 100 million x 27,11,111
[30+30+30+30+2] [360/2] (122/180) x 4%
Actual days/360 124 days 180 days 100 million x 27,55,556
[31+30+31+30+2] [360/2] (124/180) x 4%
Actual days/reference 124 days 184 days 100 million x 26,95,652
period [31+30+31+30+2] [31+30+31+30+31+31] (124/184) x 4%

29. Calculation of interest rate [May 2012 RTP, Nov 2017 RTP, May 2018, Nov 2010, May 2014 MTP,
Nov 2017 MTP]
Derivative Bank entered into a swap arrangement on a principal of Rs. 10 crores and agreed to receive
MIBOR overnight floating rate for a fixed payment on the principal. The swap was entered into on
Monday, 2 August, 2010 and was to commence on 3 August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.
Required:
• The nature of this swap arrangement
• If Derivative Bank received Rs. 317 net on settlement, calculate Fixed rate and interest under
both legs.

Notes:
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❖ Sunday is Holiday.
❖ Work in rounded rupees and avoid decimal working.
Answer:
• The given swap arrangement is Plain Vanilla Overnight Index Swap (OIS).

WN 1: Computation of interest to be paid by floating rate payer:

Date ROI Opening balance Interest Closing balance
August 3 (Tuesday) 7.75% 10,00,00,000 21,233 10,00,21,233
August 4 (Wednesday) 8.15% 10,00,21,233 22,334 10,00,43,567
August 5 (Thursday) 8.12% 10,00,43,567 22,256 10,00,65,823
August 6 (Friday) 7.95% 10,00,65,823 21,795 10,00,87,618
August 7 (Saturday) 7.98% 10,00,87,618 43,764 10,01,31,382
August 9 (Monday) 8.15% 10,01,31,382 22,358 10,01,53,740
Total 1,53,740
• Interest under floating leg = Rs.1,53,740
• Derivative bank is paying fixed rate and receiving floating rate. Under net settlement they are
receiving Rs.317. This is possible if interest under fixed leg is lower than interest under floating leg
• Interest under fixed leg = 1,53,740 – 317 = 1,53,423

Computation of fixed rate:


Is ud id lg =  s  RI    = ,,


 
 = , ,       = .  %
  

30. Interest rate swap [Nov 2011 RTP]

Euroloan Bank has a differential advantage in issuing variable-rate loans, but wishes to avoid the income risk
associated with such loan. Currently bank has a portfolio €25,000,000 loans with PLR + 150bp, reset monthly
PLR is currently 4%. IB an investment bank has arranged for Euroloan to swap into a fixed interest payment
of 6.5% on notional amount of loan for its variable interest income. If Euroloan agrees to this, what amount
of interest is received and given in the first month? Further, assume that PLR increased by 200 bp. Compute
interest income received and paid with the increase in PLR.
Answer:
WN 1: Computation of net settlement at current PLR of 4%
Particulars Calculation Amount
Interest received from customer 2,50,00,000 x 5.5% x (1/12) 1,14,583.33
Interest paid to swap intermediary Same as above 1,14,583.33
Interest received from swap intermediary 2,50,00,000 x 6.5% x (1/12) 1,35,416.67
Net inflow from swap intermediary 1,35,416.67 – 1,14,583.33 20,833.34

WN 2: Computation of net settlement if PLR increases by 200 bps

Particulars Calculation Amount
Interest received from customer 2,50,00,000 x 7.5% x (1/12) 1,56,250
Interest paid to swap intermediary Same as above 1,56,250
Interest received from swap intermediary 2,50,00,000 x 6.5% x (1/12) 1,35,416.67
Net outflow to swap intermediary 1,56,250 – 1,35,416.66 20,833.34

31. Selection of source of funding [Nov 2019]:

A German subsidiary of an US based MNC has to mobilize 1,00,000 Euro's working capital for the next 12
months. It has the following options:
Loan from German Bank 5% per annum
Loan from US Parent Bank 4% per annum
Loan from Swiss Bank 3% per annum
Banks in Germany charge an additional 0.25% p.a. towards loan servicing. Loans from outside Germany
attract withholding tax of 8% on interest payments. If the interest rates given above are market determined,
examine which loan is the most attractive using interest rate differential.

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Answer:
Computation of net cost under each of the options:
Cost in Germany Borrowing rate + Loan servicing cost 5.25%
5% + 0.25%
Cost in USA Borrowing rate + Premium/Discount 5.31%
%
+ .%
 − .
.% + .%
Cost in Switzerland Borrowing rate + Premium/Discount 5.20%
%
+ .%
 − .
.% + .%
Conclusion:
• German Subsidiary should borrow money from Swiss Bank as the effective cost is lowest

Computation of exchange rate premium in USA and Switzerland:

Premium in USA:
 + H u R =  + Fig u R   + iu
 + % =  + %   + iu
.
 + iu = ;  +  = .
.
 = .   . %

Premium in Switzerland:
 + H u R =  + Fig u R   + iu
 + % =  + %   + iu
.
 + iu = ;  +  = .
.
 = .   . %

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