Chapter - 8

INTEREST RATE RISK

MANAGEMENT
Learning Outcomes
After going through the chapter student shall be able to understand:
 Interest Rate Risk
 Hedging Interest Rate Risk
(a) Traditional Methods
(b) Modern Methods including Interest Rate Derivatives

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 Page 8.2 STRATEGIC FINANCIAL MANAGEMENT
CALCULATION OF FORWARD INTEREST RATE
Question No. 1A [Nov-2008-4M] [RTP- Nov-2009] [Q-17A of Security Valuation]
The following is the Yield structure of AAA rated debenture:
Period Yield (%)
3 months 8.5%
6 months 9.25
1 year 10.50
2 years 11.25
3 years and above 12.00
(i) Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of the bond
having a maturity of 5 years? Assume that the bond is fairly priced at the moment at 1,000.
Ans: (i) IFR Year 2 = 12%; IFR Year 3 = 13.52%; % decrease = 1.77%

Question No: 1B [Nov-2013-5M] [Q-17B of Security Valuation]

ABC Ltd. Issued 9% , 5 year bonds of Rs. 1000/- each having a maturity of 3 years. The present rate of interest is
12% for one year tenure. It is expected that forward rate of interest for one year tenure is going to fall by 75 basis
points and further by 50 basis for every next year in future for the same tenure. This bond has a beta value of 1.02
and is more popular in the market due to less credit risk.
Calculate
(i) Intrinsic value of bond
(ii) Expected price of bond in the market

Question No: 1C [Nov-2007-6M]

From the following data for Government securities, calculate the forward rates:
Face value (Rs.) Interest rate Maturity (Year) Current price (Rs.)
1,00,000 0% 1 91,500
1,00,000 10% 2 98,500
1,00,000 10.5% 3 99,500
[As-CMA-Dec-2014-8M] [CMA-MTP-Dec-2018]

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No: 1.1 [May-2010-8M]
Consider the following data for government securities:
Face Value ($) Interest rate (%) Maturity (Years) Current Price ($)
1,00,000 0 1 91,000
1,00,000 10.5 2 99,000
1,00,000 11 3 99,500
1,00,000 11.5 4 99,900
Calculate the forward interest rates.
[CMA-Compendium]
Ans: 1 st year FR = 9.89%; 2 nd Year FR = 12.40%; 3 rd Year FR = 11.5%, 4 th Year FR = 12.80%

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 INTEREST RATE RISK MANAGEMENT Page 8.3
Question No. 1.2 [Nov-2018-New-8M] [MTP-May-2021-New-8M] [MTP-May-2021-Old-8M]
An Indian company obtains the following quotes (/$)
Spot: 35.90/36.10
3-Months forward rate: 36.00/36.25
6-Months forward rate: 36.10/36.40
The company needs $ funds for six months. Determine whether the company should borrow in $ or .
Interest rate are: 3-Months Interest rate: : 12% , $: 6%
6-Months Interest rate: : 11.50% , $ 5.5%
Also determine what should be the rate of interest after 3 months to make the company indifferent between 3-
months borrowing and 6-months borrowing in the case of:
(i) Rupee borrowing
(ii) Dollar borrowing
Note: For the purpose of calculation you can take the units of dollar and rupee as 100 each.
Ans: (a) $ Borrowing: 3740.10;  Borrowing:  3817.58 (b)  Borrowing: 10.68%; $ Borrowing: 4.93%

Question No. 1.3 [Jan-2021-New-4M]

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of 1,000:
Maturity (Years) Yield to Maturity (YTM)
1 10%
2 11%
3 12%
Assume that the term structure of interest rate will remain the same.
You are required to
(i) Calculate the implied one year forward rates
(ii) Expected Yield to Maturity and prices of one year and two year Zero Coupon Bonds at the end of the first
Year.
Ans: (i) 12.01%; 14.03% (ii) 12.01%; 13.02%

Question No. 1.4 (Similar to 1B) [MTP-May-2021-New/Old-8M]

ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of Rs. 1,000 each.
The annual spot yield curve for similar risk class of Bond is as follows:
Year Interest Rate
1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%

(i) Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to its popularity because
of lesser risk.
(ii) Interpret the nature of the above yield curve and reasons for the same.
Note: Use PV Factors upto 4 decimal points and value in Rs. upto 2 decimal points.
Ans: (i)  1,022.63
(ii) The given yield curve is inverted yield curve. The main reason for this shape of curve is expectation for forthcoming recessi on
when investors are more interested in Short-term rates over the long term.

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 Page 8.4 STRATEGIC FINANCIAL MANAGEMENT
FORWARD RATE AGREEMENT (FRA)
Question No. 2A [RTP-Nov-2012]
TM Fincorp has bought a 6X9  100 crore Forward Rate Agreement (FRA) at 5.25%. on fixing date reference
rate i.e. MIBOR turns out 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 amount.
(Assume 360 days in a year)
Ans: (a) 25 basis point; (b)  6,16,500
Question No. 2B [MTP-May-2014-5M]]
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.
Ans: (i) Short position; (ii) 3×6FRA; (iii) $9345.79

Question No. 2C [Nov-2019-New-8M] [SM-New] [RTP-Nov-2018-New] [As May-2013-8M]

Ankush ltd. Has a plan to raise an amount of 50 crores for a period of 3 months, 6 months from now. The current
rate of interest is 9% but it may rise in 6 months time. The company wants to hedge itself against the increase in
interest rate. Bank of India has quoted a forward rate agreement (FRA) at 9.1% per annum. Find the effect of FRA
and actual interest cost to ankush Ltd. If the actual rate after 6 months happens to be 9.5% or 8.5%.
[CS-June-2009-4M]
Ans: When 9.5%: Settl amt = Receive 4,88,400; When 8.5% Amt. = Pay  7,34,394
Actual interest cost = 9.1% in both case

Question No. 2D
MNC rolls over a $25 million loan priced at LIBOR on a three-month basis. The company feels that interest rates
are rising and that rates will be higher at the next roll- over date in three months. Suppose the current LIBOR is
5.4375%. Explain how MNC can use FRA at 6% offered by a bank to reduce its interest rate its FRA? Assume the
three month period as 90 days.
[CMA-MTP-June-2014-3M]
Ans: (a) Buy 3× 6 FRA at 6%. If interest rate rise to 6.25% (Assumed) then settlement amount = 30,750

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 INTEREST RATE RISK MANAGEMENT Page 8.5

ARBITRAGE IN FRA
Question No. 3A [RTP-Nov-2017] [RTP-May-2018-New] [May-2010-New-8 Marks]
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 NIL.
1. What should be 3 months FRA rate at 3 months forward?
2. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA at 6.50 – 6.75%.
Is any arbitrage opportunity available?
Calculate profit in such cases.
[CMA-RTP-Dec-2018] [CMA-PTP-June-2014-8M]
Ans: (i) 5.44%; (ii) Yes, arbitrage opportunity available; Gain = $.005 for every 1$ borrowed

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 3.1
The following market data is available:
Period MIBOR
3 months 8.5%
6 months 9.25
1 year 10.50
2 years 11.25
Bank quoting 6 × 12 FRA = 12.00% - 12.50%
(i) Is any arbitrage opportunity available from the rate quoted above? Quantify the amount of arbitrage, if any.
(ii) Is your answer change, if the rate quoted by bank is: 6 × 12 FRA = 11.00 – 11.50%
Ans: (i) Yes, Gain = 0.004 for every Rupee borrowed. (ii) Yes, There will be no Arbitrage in this case

INTEREST RATE FUTURE

Question No. 4A [RTP-May-2018-New] [RTP-May-2014] [RTP-May-2021-New] [RTP-May-2021-Old]
Electra space 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:
(a) How a FRA, shall be useful if the actual interest rate after 6 months turnout to be: (i) 4.5% (ii) 6.5%
(b) How 3 moths Future contract shall be useful for company if interest rate turns out as mentioned in part (a)
above.
Ans: (a) By using 3 × 9 FRA, the firm can lock in interest at 5.94% for borrowing
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 Page 8.6 STRATEGIC FINANCIAL MANAGEMENT
Question No. 4B [MTP-May-2021-New-8M]
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 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.

INTEREST RATE SWAP

Question No. 5A [July-2021-New-8M] [Nov-18-New-4M] [SM-OLD] [May-15-Nepal-8M] [Nov-10-8M]
[RTP-Nov-09] [RTP-May-2010] [MTP-May-2021-New-4M] [MTP-May-2021-Old-4M]
A Dealer quotes “All-in-cost” for a generic swap at 8% against six months LIBOR flat. If the notional principal
amount of swap is 6,00,000.
(i) Calculate semi-annual fixed payment
(ii) Find the first floating rate payment for (i) above, if the six-month period from the effective date of swap
to the settlement date comprises 181 days and that the corresponding LIBOR was 6% on the effective
date of swap
(iii) 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.
[CMA-PTP-June-2015-6M] [CMA-PTP-Dec-2014-(2+2+2)=6M] [CMA-SM-2016]
Ans: (i) Fixed Pmt = 24,000; (ii) floating rate pmt = 18,100; (iii) 5,900
Question no. 5B
[MTP-Nov-2018-New-8M] [May-2018-New-8M] [SM-NEW] [SM-OLD] [Nov-2017-8M] [RTP-Nov-2017]
[Nov-2010-8M] [RTP-May-2012] [RTP-Nov-2014] [MTP-May-2014-8M]
Bharat Bank entered into a plain vanilla swap through on OIS (Overnight Index swap) on a principal of 1 crore and
agreed to receive MIBOR overnight floating rate for a fixed payment on the principal. The swap was entered into
on Monday, 10th July, 2017 and was to commence on and from 11th July, 2017 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
8.75%, 9.15%, 9.12%, 8.95%, 8.98%, 9.15%
If Bharat bank received 417 net on settlement, calculate fixed rate and interest under both legs.
Notes: (i) Sunday is holiday
(ii) Work in rounded rupees and avoid decimal working.
(iii) Consider 365 days in a year
Ans: Interest under floating leg = 17,294 ; Fixed leg = 16877; Fixed rate =

Question No. 5C [RTP-May-2018-New/Old] [MTP-Nov-2021-6M]

TMC Holding Ltd. has a portfolio of shares of diversified companies valued at  400 crore enters into a swap
arrangement with None Bank on the terms that it will get 1.15% quarterly on notional principal of  80 crore in
exchange of return on portfolio which is exactly tracking the Sensex which is presently 21600
CALCULATE the net payment to be received/ paid at the end of each quarter if Sensex turns out to be 21,860;
21,780; 22,080 and 21,960.
Ans: - 0.2148; 6.0640; - 0.9096; 6.7740

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 INTEREST RATE RISK MANAGEMENT Page 8.7

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No: 5.1 [MTP-Nov-2020-8M-New/Old] [RTP-Nov-2021]
Consider the Derivative Bank entered into a swap arrangement on a principal of  10 crores and agreed to receive
MIBOR overnight floating rate for a fixed payment on the principal. The swap was entered into on Monday, 19th
August, 2019 and was to commence on 20th August, 2019 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
8.15%, 7.98%, 7.95%, 8.12%, 8.15%, 7.75%.
If Fixed Rate of Interest is 8%, then evaluate
(i) the nature of this Swap arrangement; (ii) the Net Settlement amounts
Notes:
(1) Sunday is Holiday; (2) Work in rounded rupees and avoid decimal working.
(3) Consider 365 days in a year.

HEDGING WITH THE HELP OF IRS

Question No. 6A
Cash Rich Ltd (CRL) has invested 50 crore in market linked securities providing it a current return of 8% with
current MIBOR of 7.5%. Of late, yield in the market have started falling adversely affecting the income of CRL.
It needs to protect the same. Professional Bank Ltd, CRL’s banker has offered a 3-year MIBOR based swap with
rates at 7.30% - 7.40%. Should CRL accept the swap what income can it lock-in for next 3 years? What would be
the advantage of the Swap? Depict the swap arrangement.
Ans: Agreement: Pay Floating and Receive Fixed;
Accept if MIBIR <7.30%; Income that can be locked = 7.8%
Question No. 6B [RTP-May-2010]
9-year Government of India security is being quoting at 10.5%. The 364 T Bill (Treasury Bill) is being quoted at
11.25. Last year Indian National Bank had issued a fixed rate bond under statutory requirement at 15% coupon for
a period of 10 year. Now when remaining 9 years are yet to expire the Bank wants to convert their fixed rate
obligation to floating rate due to anticipation of decline in interest rates. Market quotation for fixed to floating rate
swap is T-Bill rate is 75/85 bps over 9-year Government of India security. If T-Bill decline 20 bps over the current
year and rises by 5 bps every year thereafter what is the effective cost of funds to Indian National Bank. To hedge
interest rate Indian National Bank undertakes swap transaction every year.
Ans: 14.98%

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 6.1 [RTP-Nov-2011]
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 bps.
Ans: Received = 135416.67; Given = 156,250
Question No. 6.2 [May-2010-10M]
ABC bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + .25% for 200 million
for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month LIBOR treating six months as
exactly half a year.
(a) What will be the “all in cost” funds to ABC Bank?

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 Page 8.8 STRATEGIC FINANCIAL MANAGEMENT
(b) Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for first three years
and LIBOR - 0.25% for remaining two years.
Given a three year swap rate of 8%, suggest the method by which the bank should achieve fixed rate funding.
Ans: (a) AIC fund = 77,50,000 (b) Arrangement in (b) compared to (a) saves 0.75% p.a. over the first three years and 0.5%
pa over final two years.

REDUCING BORROWING COST WITH THE HELP OF IRS

Question No. 7A [RTP-Nov-2008-Old]
Electrometric 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.
Electrometric and Tim Software Ltd., can obtain loans at the rate given below:
CD (Company Deposit) Mumbai Inter-bank money market
with Fixed Rate with variable rate
Electrometric Ltd T*+ 0.50 MIBOR + 0.10
Tim Software Ltd. T* + 2.10 MIBOR + 060
*Here T means the risk free 15 years Government Bonds.
Electrometric 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 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?
Ans: likely cost for Electrometric will be (MIBOR – 0.45%); The cost for Tim Software will be (T+1.75)%.
Question No. 7B
Company A has outstanding debt on which it currently pays fixed rate of interest at 9.5%. The company intends to
refinance the debt with a floating rate interest. The best floating rate it can obtain is LIBOR + 2%. However, it does
not want to pay more than LIBOR. Another company B is looking for a loan at a fixed rate of interest to finance
its exports.
The best rate it can obtain is 13.5%, but it cannot afford to pay more than 12%. However, one bank has agreed to
offer finance at a floating rate of LIBOR + 2%. Citibank is in the process of arranging an interest rate swap between
these two companies.
(i) With a schematic diagram, show how the swap deal can be structured,
(ii) What are the interest savings by each company?
(iii) How much would Citi bank receive?
[CMA-June-2017-8M] [CMA-PTP-June-2014-(6+4+5)=15M]
Ans: (i) Diagram (ii) Saving: A = 200bps; B = 150bps; (iii) Citibank = 50bps

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 7.1
Company ABC and XYZ have been offered the following rate per annum on a $200 million five-year loan:
Fixed Floating
Company ABC 12 LIBOR + 0.1%
Company XYZ 13.4 LIBOR + 0.6%
Company ABC requires a floating-rate loan. Design a swap that will net a bank acting as intermediary at 0.1%
per annum and be equally attractive to both the companies.
[CMA-RTP-Dec-2018] [CMA-PTP/MTP-Dec-2014-New-10M] [CMA-PTP-June-2015-New-10M] [CMA-SM-2016]
Ans: Effective Cost to ABC = LIBOR - .30%; to XYZ = 13%

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 INTEREST RATE RISK MANAGEMENT Page 8.9
Question No. 7.2 [RTP-Nov-2011]
A Ltd. is considering a 50 crores 3 year interest rate swap. The company is interested in borrowing at floating rate
however, due to its good credit rating, it has a comparative over lower rated companies in fixed rate market. It can
borrow at fixed rate of 6.25% or floating rate MIBOR+0.75%.
Presently, MIBOR is 5.25% but is expected to change in 6 months due to political situation in the country. X Ltd.
an intermediary bank agreed to arrange a swap. The bank will offset the swap risk with a counter party (B. Ltd.) a
comparative lower credit rated company, which could borrow at a fixed rate of 7.25% and floating rate of MIBOR
+ 1.25%. X Ltd. would charge  12,00,000 per year as its fee from each party. Mr. Fin the CFO, of A Ltd. desires
that A Ltd. should receive 60% of any arbitrage saving (before payment of fees) from the swap as A Ltd. enjoying
high credit rating.
Any fees paid to the bank are tax allowable. The applicable tax rate is 30%.
You are required to:
(a) Evaluate whether the proposal is beneficial for both parties or not.
(b) Assuming that MIBOR was to increase to 5.75% immediately after political crisis over and shall remain
constant for the period of swap. Evaluate the present value of savings from the swap for A Ltd., assuming
that interest payment are made semi- annually in arrears.

Question No. 7.3

Union Bankers ltd offer the following interest rates to two of its customers for a loan of ₹ 150 Crores, repayable
in 7 years.
Company DHARAM Co. SMOOTH-TECH Ltd.
Nature of activity Supply and installation of security Providing IT support to various airlines,
systems for homes, offices and shipping Companies and Government
corporate Surveillance Companies
Year in industry 25 1.5
Market position Market leader Market Extrants in fant
Rating by UBL A++ B+
Floating interest Rates MIBOR -0.50% MIBOR + 1%
Fixed interest rates 10% 12.50%
Share in the Net gain on 60% 40%
account of interest Rate
Swap
Assuming principle amount is repaid at the end of the seven years, what is the effective gain in % as well as in value
for both companies, if they enter into a swap arrangement for reducing interest effect.
Also ascertain the interest cost (in %) for both companies.
[CMA-June-2017-New-8M] [CMA-June-2015-10M] [CMA-SM-2016]

CURRENCY SWAP
Question No. 8A
[May-2011-New-8 Marks] [RTP-NOV-2013] [MTP-Nov-2013-8M] [RTP-May-2020-New/Old]
A Inc. and B Inc. intend to borrow $2,00,000 and $2,00,000 in ¥ respectively for a time horizon of one year. The
prevalent interest rates are as follows:
Company ¥ Loan $ Loan
A Inc. 5% 9%
B Inc. 8% 10%
The prevailing exchange rate is $1 = ¥120.

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 Page 8.10 STRATEGIC FINANCIAL MANAGEMENT
They entered in a currency swap under which it is agreed that B Inc will pay A Inc@ 1% over the ¥ loan interest
rate which the later will have to pay as result of the agreed currency swap whereas A Inc will reimburse interest to
B inc only to the extent of 9%. Keeping the exchange rate invariant, quantify the opportunity gain or loss
component of ultimate outcome resulting from the designed currency swap.
Ans: A Inc = $2000; B Inc = ¥240000.
Question No. 8B [RTP-Nov-2012]
Drilldip Inc., a US based company, has won a contract in India for drilling oil field. The project will require an
initial investment of  500 crore. The oil field along with equipments will be sold to Indian Government for  740
crore in one year time. Since the Indian Government will pay for the amount in Rupee () the company is worried
about exposure due exchange rate volatility.
You are required to:
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US $ =  50 in one year, then should the
company should opt for this option or should it just do nothing. The spot rate after one year is expected to be 1US
$ =  54. Further you may also assume that the Drilldip can also take a US $ loan at 8% p.a.

Question No. 8C [May-2019-Old-8M] [This is Wrong Question but Corrected in Nov-2020 -See 8D below]
[MTP-May-2021-New-8M] [MTP-Nov-2021-8M]
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
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 ?

Question No. 8D [Nov-2020-New-8M]

IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its subsidiary in India and face the
following interest rates:
Company IB Zaki
INR floating rate BPLR + 0.50 % BPLR + 2.50 %
JPY (Fixed rate) 2% 2.25%
Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow JPY at a fixed rate. The amount of
loan required by both the firms is same at the current exchange rate. A financial institution may arrange a swap
and requires 25 basis points as its commission. Gain, if any, is to be shared by the firms equally.
You are required to find out:
(i) Whether a swap can be arranged which may be beneficial to both the firms?
(ii) What rate of interest will the firms end up paying?

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 INTEREST RATE RISK MANAGEMENT Page 8.11

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 8.1 [As May-2019-Old-8M]
Companies M and N have the following interest rates:
M N
U.S. Dollars (floating rate) LIBOR+0.5% LIBOR+1%
Canadian Dollars Fixed Rate 6% 4.5%
M wants to borrow Canadian Dollars at fixed rate while N wants US dollars at floating rate.
F, a financial institution charges, if it arranges a swap, 50 basis points spread.
Design, if possible, a swap to share the benefits equally between M and N. Discuss the steps of action in the swap
and arrive at the final effective interest rate for M and N.
In case a swap is not possible, give your calculations to substantiate why it is not possible.
[CMA-RTP-Dec-2018] [CMA-Dec-2017-New-8M] [CMA-SM-2016] [CMA-MTP-June-2021-6M]

Question No. 8.2

Y, a British firm with a US subsidiary, seeks to refinance some of its existing British pound debt to include floating
rate obligations. The best floating rate it can obtain in London is LIBOR + 2.0%. Its current debts are as follows:
US$ 10 million owed to CT Bank at 9.5% (fixed annually); and
£ 5 million owed to MD Bank at 9.5% (fixed) annually.
HRS Company wishes to finance exports to Britain with £ 3 million of pound denominated fixed rate debt for six
months. HRS is unable to obtain a fixed interest rate in London for less than 13.5% interest because of its lack of
credit history in the UK. However, Lloyds Bank is willing to extend a floating rate British pound loan at LIBOR +
2%. HRS, however, cannot afford to pay more than 12%.
Assume that Y is in a strong bargaining position and can negotiate the best deal possible, but HRS will not pay over
12%. Assume further that transaction costs are 0.5% and exchange rates are stable.
Can Y and HRS help each another by an interest rate swap? If so, how? Compute the amount of gains for Y, HRS
and the Swap Dealer.
Illustrate the effective post-swap interest rates of each party with a diagram. What are the effective interest rates for
each party over the six months period of the swap?
[CMA-June-2018-New-8M]
Question No. 8.3 Moved to Q No - 8C

Question No. 8.4

An Indian business house has decided to borrow US$ for its New York subsidiary, and an American multinational
has made up its mind to borrow Indian rupees for its Indian subsidiary. The amount required by the two companies
is the same at the current exchange rate. The companies have been quoted the following interest rates.
On rupee loan in India On US$ loan in America
Indian Company 9.0% 4.0%
American Company 9.5% 3.0%
Both the Indian business house and the American multinational carries out their banking operations through the
same multinational bank. The multinational bank comes to know of the situation faced by the two companies and
plans to design a swap. As the bank will be assuming all foreign exchange risk, it plans to receive total 50 basis
points per annum and also plans to make the swap equally attractive to the two companies. What will the design
of the swap be?
[CMA-MTP-June-2020-10M]

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 Page 8.12 STRATEGIC FINANCIAL MANAGEMENT
INTEREST RATE OPTION OR INTEREST RATE GUARANTEE
Question No. 9A
[RTP-Nov-2019-New] [RTP-Nov-2014] [RTP-Nov-2020] [RTP-Nov-2020-Old] [MTP-Nov-21-6M]
Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate Agreement). They want
to borrow a sum of 100 crores after 2 years for a period of 1 year. Bank has calculated Yield Curve of both
companies as follows:
Year XYZ Ltd. ABC Ltd.*
1 3.86 4.12
2 4.20 5.48
3 4.48 5.78
*The difference in yield curve is due to the lower credit rating of ABC Ltd. compared to XYZ Ltd.
(i) 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.
(ii) 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 Ltd. if interest in 2 years turns out to be (a) 4.50%; (b) 5.50%
Ans: (i) (a) 5.04%; (b) 6.38%; (ii) (a) 4.60Cr; (b) 5.14Cr

INTEREST RATE CAP

Question No. 10A [RTP-Nov-2012] [RTP-May-2013]
Suppose that a 1-year cap rate of 8% and a notional amount of  100 crore. The frequency of settlement is quarterly
and the reference rate is 3M MIBOR. Assume that 3 month MIBOR for the next four quarters is as 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.
Ans: Q-1=0.175 Cr; Q-2=Nil; Q-3=Nil; Q-4=0.05 Cr.

Question No. 10B [MTP-Nov-2019-New-8M] [RTP-May-2011] [As May-13-5M]

XYZ plc borrows £ 20 million of 6 months LIBOR + 0.25% for a period of two years. Mr. Toby, Manager of XYZ
anticipates a rise in LIBOR, hence proposed to buy a cap option from an ABC Bank at strike rate of 7%. The lump
sum premium is 1% for the whole of the three resets period and the fixed rate of interest is 6% p.a. The actual
position of LIBOR during the forth coming reset period is as follows:

Reset Period LIBOR

1 8.00%
2 8.50%
3 9.00%
You are required to show how far interest-rate risk is hedged through cap option. Ans: 2,31,519

Question No. 10C [Nov-2017-8M] [MTP-II-Nov-2021-6M] [RTP-May-2022] [MTP-May-2022-8M]

A textile manufacturer has taken floating interest rate loan of 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.

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 INTEREST RATE RISK MANAGEMENT Page 8.13
(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 8.5% p.a.
(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1 st October, 2012 and actual
rate of interest on the respecting 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 9% and 8.25%. Show how the settlement will
be executed on the perspective interest due dates.

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 10.1 [RTP-May-11-New]
The following details are related to the borrowing requirements of two companies ABC Ltd. And DEF Ltd.
Company Requirement Fixed Rates Offered Floating Rates Offered
ABC Ltd Fixed Rupee Rate 4.5% PLR + 2%
DEF Ltd. Floating Rupee Rate 5% PLR + 3%
Both Companies are in need of 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 period maturities are as follows:
Maturity (Years) PLR (%)
1 2.75
2 3.00
3 3.20
4 3.30
5 3.375
DEF Ltd. Has bought an interest rate Cap at 5.625% at an upfront premium payment of 0.25%
(a) You are required to exhibit how these two companies can reduce their borrowing cost by adopting swap
assuming that gains resulting from swap shall be share equally among them.
(b) Further calculate cost of funding to these two companies assuming that expectation theory holds good for the 4
years.

Question No. 10.2

A company has borrowed $200 million on floating basis for 3 years. The interest rates are reset every year. The
spread over LIBOR is 25 bps. The company buys a 3 year cap on a 1-year LIBOR with a strike rate of 9% and
having a face value of $200 million. The cap carries a premium of 2% of face value or $4 million. Current 1 year
LIBOR is 9%. If the LIBOR at the end of 1,2 and 3 years are 9.5% 8.5% and 10%. What is the cash flow from cap
each year? Amortize premium equally over three years.
[CMA-RTP/MTP-Dec-2014-New-7M]
Ans:
Time Cash Flow Loan Amortization of premium Cash Flow from Cap Total
0 + 20,00,00,000 --- --- + 20,00,00,000
1 − 1,95,00,000 − 13,33,333 +10,00,000 − 1,98,33,333
2 − 1,75,00,000 − 13,33,333 --- − 1,88,33,000
3 − 2,05,00,000 − 13,33,333 +20,00,000 − 1,98,33,333
3 − 20,00,00,000 --- --- − 20,00,00,000

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 Page 8.14 STRATEGIC FINANCIAL MANAGEMENT
INTEREST RATE FLOOR
Question No. 11A [RTP-Nov-2012] [RTP-May-2013]
Suppose that a 1-year floor rate of 4% and a notion amount of  200 crore. The frequency of settlement is
quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for the next four quarter is as
shown below.
Quarters 3-month MIBOR (%)
1 4.70
2 4.40
3 3.80
4 3.40
You are required to compute payoff for each quarter.
Ans: Q-1=Nil; Q-2=Nil; Q-3=0.1 Cr; Q-4= 0.3 Cr

 TEST YOUR KNOWLEDGE

’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Question No. 11.1
DY has purchased 400 million cap (i.e., call options on interest rates) of 9 percent at a premium of 0.65 percent
of face value. 400 million floor (i.e., put options on interest rates) of 4 percent is also available at premium of 0.69
percent of face value.
(i) If interest rates rise to 10 percent, what is the amount received by DY? What are the net savings after
deducting the premium?
(ii) If DY also purchases a floor, what are the net savings if interest rates rise to 11 percent? What are the net
savings if interest rates fall to 3 percent?
(iii) If, instead, DY sells (writes) the floor, what are the net savings if interest rates rise to 11 percent? What if
they fall to 3 percent?
(iv) What amount of floors should it sell in order to compensate for its purchases of caps, given the above
premiums?
[CMA-RTP-June-2014]
INTEREST RATE COLLAR
Question No. 12A [RTP-May-2019-New] [MTP-Nov-2018-New-8M] [RTP-May-2014] [May-2022-8M]
XYZ Inc. issues a £ 10 million floating rate loan on July 1, 2016 with resetting of coupon rate every 6 months equal
to LIBOR + 50 bp. XYZ is interested in a collar strategy by selling a Floor and buying a Cap. XYZ buys the 3 years
Cap and sell 3 years Floor as per the following details on July 1, 2016:
Notional Principal Amount $10Mill
Reference Rate 6 Month LIBOR
Strike rate 4% for Floor and 7% for Cap
Premium 0*
*Since Premium paid for Cap = Premium received for Floor Using the following data you are required to
determine:
(i) Effective interest paid out at each reset date,
(ii) The average overall effective rate of interest p.a.
Reset Date LIBOR (%)
31-12-2016 6.00
30-06-2017 7.50
31-12-2017 5.00
30-06-2018 4.00
31-12-2018 3.75
30-06-2019 4.25
15,99,999 365
Ans: (i) 327671; 347123; 277260; 210753; 201644; 235548; (ii) 5.33% (i.e. × × 100)
100,00,000 1095

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