CA FINAL ADVANCED FINANCIAL MANAGEMENT
INTEREST RATE RISK
12 MANAGEMENT
CATEGORY A
Question 1
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 firm equally.
You are required to find out:
(i) Whether a swap can be arranged which may be beneficial to both the firm?
(ii) What rate of interest will the firms end up paying?
(MTP 8 Marks March’23, PYP 8 Marks Nov 20)
Answer :
Though Company IB has an advantage in both the markets but it has comparative more
advantage in the INR floating-rate market. Company Zaki has a comparative advantage
in the JPY fixed interest rate market.
However, company IB wants to borrow in the JPY fixed interest rate market and company
Zaki wants to borrow in the INR floating-rate market. This gives rise to the swap
opportunity.
IB raises INR floating rate at BPLR + 0.50% and Zaki raises JPY at 2.25%
Total Potential Gain = (INR interest differential) - (Yen rate differential)
= (BPLR + 2.50% – BPLR + 0.50%) + (2% – 2.25%) = 1.75%
Less Banker’s commission (To be shared equally) = 0.25%
Net gain (To be shared equally: 0.75% each) = 1.50%
Interest Rate Risk Management - COMPILATION
1 PROF. CA RAHUL DANAIT
CA FINAL ADVANCED FINANCIAL MANAGEMENT
(i) Yes, a beneficial swap can be arranged
(ii) Effective cost of borrowing = pays to lenders + pays to other party – receives from
other party + banker’s commission
IB = BPLR + 0.50% + 1.125%* – (BPLR + 0.50%) + 0.125% = 1.25%
(* has been arrived as 2% – 0.75% – 0.125%)
Zaki = 2.25% + BPLR + 0.50% – 1.125% + 0.125% = BPLR + 1.75%
Question 2
K Ltd. currently operates from 4 different buildings and wants to consolidate its operations
into one building which is expected to cost ` 90 crores. The Board of K Ltd. had approved
the above plan and to fund the above cost, agreed to avail an External Commercial
Borrowing (ECB) of GBP 10m from G Bank Ltd. on the following conditions:
• The Loan will be availed on 1st April, 2019 with interest payable on half yearly rest.
• Average Loan Maturity life will be 3.4 years with an overall tenure of 5 years.
• Upfront Fee of 1.20%.
• Interest Cost is GBP 6 months LIBOR + Margin of 2.50%
• The 6 month LIBOR is expected to be 1.05%
K Ltd. also entered into a GBP-INR hedge at 1 GBP = INR 90 to cover the exposure on
account of the above ECB Loan and the cost of the hedge is coming to 4.00% p.a.
As a Finance Manager, given the above information and taking the 1 GBP = INR 90:
(i) Calculate the overall cost both in percentage and rupee terms on an annual basis.
(ii) What is the cost of hedging in rupee terms?
(iii) It K Ltd. wants to pursue an aggressive approach, what would be the net gain/loss
for K Ltd. If the INR depreciates/appreciates against GBP by 10% at the end of the
5 years assuming that the loan is repaid in GBP at the end of 5 years?
Ignore time value and taxes and calculate to two decimals.
(PYP 8 Marks May‘19)
Answer:
Calculation of Overall Cost
Upfront Fee (GBP 10M @ 1.20%) ` 1,20,000
Interest Payment (GBP 10M x 3.55% x 3.4) ` 12,07,000
Hedging Cost (GBP 10M x 4% x 3.4) ` 13,60,000
Total ` 26,87,000
Or ` 2.687 million
Interest Rate Risk Management - COMPILATION
2 PROF. CA RAHUL DANAIT
CA FINAL ADVANCED FINANCIAL MANAGEMENT
2.687 million 1
Overall cost in % terms on Annual Basis = x
(1,00,00,000 – 1,20,000) 3.4
2.687 1
= x x 100 = 8%
9.88 3.4
2.687
Overall Cost in Rupee terms @ GBP 1 = ` 90 x x 100 = ` 711.26 lakhs
3.4
OR
2.687 million 1
Overall cost in % terms on Annual Basis = x
(1,00,00,000) 3.4
2.687 1
= x x 100 = 7.9%
1.00 3.4
Overall Cost in Rupee terms @ GBP 1 = 10,000,000 x 7.90% x 90
= ` 71,100,000
OR
Calculation of Overall cost
Interest & Margin (A) = 3.55%
Hedging cost (B) = 4% 7.55%
Onetime fee = 1.20%
Average loan maturity = 3.4 years
Per annum cost 1.2/3.4 (C) = 0.35%
Annual overall cost in % terms (A+B+C) = 7.9%
Overall Cost in Rupee terms@ GBP 1 = 10,000,000 x 7.90% x 90
= ` 71,100,000
(ii) Cost of Hedging in terms of Rupees
` 13,60,000 x 90 = ` 12,24,00,000 = ` 12.24 crores in Total
OR
GBP 10,000,000 x 90 x 4% = ` 3,60,00,000 on Auual Basis
(iii) If K Ltd. pursues an aggressive approach, the Gain/Loss in INR Depreciation /
Appreciation shall be computed as follows:
(a) If INR depreciates by 10%
Re. loss per GBP = 90 x 10% = `9
Total Losses GBP 10M = ` 90 million
Less: Cost of Hedging = ` 36 million
Net Loss = ` 54 million
Interest Rate Risk Management - COMPILATION
3 PROF. CA RAHUL DANAIT
CA FINAL ADVANCED FINANCIAL MANAGEMENT
(b) If INR appreciates by 10%
Rs. Gains per GBP = ` 90 x 10% = `9
Total Gain on Repayment of loan = 90 million
Add: Saving in Cost of Hedging = 36 million
Net Gain = 126 million
Question 3
MPD Ltd. issues a ` 50 million Floating Rate Loan on July 1, 2018 with resetting of coupon
rate every 6 Months equal to LIBOR + 50 bps.
MPD is interested in an interest rate Collar Strategy of selling a Floor and buying a cap.
MPD buys the 3 years cap and sell 3 years Floor as per the following details on July 1,
2018:
Principal Amount `50 million
Strike Rate 5% for Floor & 8% for Cap
Reference Rate 6 months LIBOR
Premium NIL, since premium paid for cap = premium received for Floor
The Reset dates & Interest rates p.a., on that dates are:
Rest Date 31/12/2018 30/06/2019 31/12/2019 30/06/2020 31/12/2020 30/06/2021
LIBOR (%) 7.00 8.00 6.00 4.75 4.25 5.25
Using the above data, you are required to determine:
(i) Effective Interest paid out at each six reset dates, (Round off to the nearest rupee)
(ii) Average overall effective rate of interest p.a. (round off to 2 decimals)
(PYP 8 Marks May ‘22)
(Same concept different figures MTP 8 Marks Oct 18, RTP May ‘19)
Answer:
The pay-off of each leg shall be computed as follows:
Cap Receipt Max {0, [Notional principal x (LIBOR on Reset date – Cap Strike Rate) x
(No. of days in settlement period/365)]
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CA FINAL ADVANCED FINANCIAL MANAGEMENT
Statement showing effective interest on each payment date:
Interest Cap
LIBOR Date of Floor Pay- Effective
Reset Date Days Payment (`) Receipts
(%) Payment off (`) Interest
LIBOR + 0.50% (`)
31-12-2018 7.00 30-06-2019 181 18,59,589 0 0 18.59,589
30-06-2019 8.00 31-12-2019 184 21,42,466 0 0 21,42,466
31-12-2019 6.00 30-06-2020 182 16,16,120 0 0 16,16,120
30-06-2020 4.75 31-12-2020 184 13,19,672 0 62,842 13,82,514
31-12-2020 4.25 30-06-2021 181 11,77,740 0 1,85,959 13,63,699
30-06-2021 5.25 31-12-2021 184 14,49,315 0 0 14,49,315
Total 1096 98,13,703
Interest Rate Risk Management - COMPILATION
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CA FINAL ADVANCED FINANCIAL MANAGEMENT
CATEGORY B
Question 4
IM 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 in JPY 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?
(MTP 8 Marks Oct 21, Mar’21)
Answer :
(i) IM has overall strong position and hence is in a comparative advantageous position
in both rates. However, it has a comparative advantage in floating-rate market.
The differential between the U.S. dollar floating rates is 2.00% per annum, and the
differential between the JPY fixed rates is 0.25% per annum. The difference between
the differentials is 1.75% per annum. The total potential gain to all parties from the
swap is therefore 1.75% per annum, or 175 basis points. If the financial intermediary
requires 75 basis points, each of IM and JI can be made 50 basis points better off.
(ii) Since the Net Benefit of 100 Basis Points to be shared equally among IM and JI
interest rate for them shall be as follows:
IM
Borrowing from Market LIBOR + 0.5%
Less: Benefit from Swap 0.5%
Net Interest LIBOR
JI
Borrowing from Market 4.25%
Less: Benefit from Swap 0.5%
Net Interest 3.75%
Interest Rate Risk Management - COMPILATION
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CA FINAL ADVANCED FINANCIAL MANAGEMENT
Question 5
XY Ltd. is planning to expand its operations in view of growing demand for its products.
For this purpose, it is considering to borrow an amount of ` 100 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 due to inflation 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 8.20% per annum.
You are required to calculate due to FRA:
(i) The actual interest rate if the Banker pays to XY Ltd. an amount of ` 9,78,952.52
(ii) The actual interest rate if XY Ltd. will pay to the Banker a sum of ` 9,80,872.98
(PYP Nov’ 24, 6 Marks)
Answer:
Final settlement amount shall be computed by using formula:
(N) (RR - FR) (dtm/DY)
=
[1 + RR(dtm/DY)
Where,
N = the notional principal amount of the agreement;
RR = Actual Reference Rate for the maturity specified by the contract prevailing on
the contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity period in days or months of the forward rate agreement
DY = Total number of days or month in a year as per convention
Accordingly,
i. If Banker pays to XY Ltd. an amount of ` 9,78,952.52 then actual interest shall be
computed as follows:
(` 100 crore) (RR - 0.082) (3/12)
` 9,78,952.52 =
[1 + RR (3/12)]
RR = 0.086
Thus, the actual interest rate happens to be 8.60% on the settlement date.
Interest Rate Risk Management - COMPILATION
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CA FINAL ADVANCED FINANCIAL MANAGEMENT
ii. If XY Ltd. pays to Banker an amount of ` 9,80,872.98 then actual interest shall be
computed as follows:
(` 100 crore) (RR - 0.082) (3/12)
= ` 9,80,872.98 =
[1 + RR (3/12)]
RR = 0.078
Thus, the actual interest rate happens to be 7.80% on the settlement date.
Interest Rate Risk Management - COMPILATION
8 PROF. CA RAHUL DANAIT