9.

Interest Rate Risk Management

Study Session 9
SOLUTION 1A
Final settlement amount shall be computed by using formula:
( )( )( / )
=
[ ( / )]
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
Contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360or
365 days.
Accordingly,
If actual rate of interest after 6 months happens to be 9.60%
(₹ )( . . )( / )
=
[ . ( / )]
(₹ )( . )
= = ₹ 4,39,453
.
Thus banker will pay Parker & Co. a sum of ₹ 4,39,453
If actual rate of interest after 6 months happens to be 8.80%
(₹ )( . . )( / )
=
[ . ( / )]

(₹ )( . )
= = - ₹ 7,33,855
.
Thus Parker & Co. will pay banker a sum of ₹ 7,33,855
Note: It might be possible that students may solve the question on basis of days instead of months (as considered
in above calculations). Further there may be also possibility that the FRA days and Day Count convention may be
taken in various plausible combinations such as 90 days/360 days, 90 days/ 365 days, 91 days/360 days or 91
days/365days.
SOLUTION 1B
(a) TM will make a profit of 25 basis points since a 6X9 FRA is a contract on 3-month interest rate in 6 months,
which turns out to be 5.50% (higher than FRA price).
(b) The settlement amount shall be calculated by using the following formula:
( )( / )
( / )
Where
N= Notional Principal Amount
RR = Reference Rate
FR = Agreed upon Forward Rate
Dtm = FRA period specified in days.
Accordingly:
( . % . %)( ∗/ )
= ₹ 6,30,032
. ( ∗/ )
Hence there is profit of ₹ 6,30,032 to TM Fincorp.
* Alternatively it can also be taken as 90 days.
SOLUTION 1C
1. 3 Months Interest rate is 4.50% & 6 Months Interest rate is 5% p.a.
Future Value 6 Months from now is a product of Future Value 3 Months now & 3 Months Future Value from
after 3 Months.
(1+0.05*6/12) = (1+0.045*3/12) x (1+i i3,6 *3/12)
i3,6 = [(1+0.05* 6/12) /(1+0.045 *3/12) – 1] *12/3
i.e. 5.44% p.a.
 9.2 INTEREST RATE RISK MANAGEMENT
2. 6 Months Interest rate is 5% p.a & 12 Month interest rate is 6.5% p.a.
Future value 12month from now is a product of Future value 6 Months from now and 6 Months Future value
from after 6 Months.
(1+0.065) = (1+0.05*6/12) x (1+ i6,6 *6/12)
i6,6 = [(1+0.065/1.025) – 1] *12/6
6 Months forward 6 month rate is 7.80% p.a.
The Bank is quoting 6/12 USD FRA at 6.50 – 6.75%
Therefore, there is an arbitrage Opportunity of earning interest @ 7.80% p.a. & Paying @ 6.75%
Borrow for 6 months, buy an FRA & invest for 12 months
To get $ 1.065 at the end of 12 months for $ 1 invested today
To pay $ 1.060# at the end of 12 months for every $ 1 Borrowed today
Net gain $ 0.005 i.e. risk less profit for every $ borrowed
# (1+0.05/2) (1+.0675/2) = (1.05959) say 1.060
SOLUTION 1D
(a) By entering into an FRA, firm shall effectively lock in interest rate for a specified future in the given it is 6
months. Since, the period of 6 months is starting in 3 months, the firm shall opt for 3 × 9 FRA locking
borrowing rate at 5.94%.
In the given scenarios, the net outcome shall be as follows:
If the rate turns out to be 4.50% If the rate turns out to be 6.50%
FRA Rate 5.94% 5.94%
Actual Interest Rate 4.50% 6.50%
Loss/ (Gain) 1.44% (0.56%)
FRA Payment / (Receipts) €50 m × 1.44% × ½ = €50m × 0.56% × ½ =
€360,000 (€140,000)
Interest after 6 months on = €50m × 4.5% × ½ = € 50m × 6.5% × ½
€50 Million at actual rates = €1,125,000 = €1,625,000
Net Out Flow € 1,485,000 €1,485,000
Thus, by entering into FRA, the firm has committed itself to a rate of 5.94% as follows:
€ , ,
×100 x = 5.94%
€ , ,
(b) Since firm is a borrower it will like to off-set interest cost by profit on Future Contract. Accordingly, if interest
rate rises it will gain hence it should sell interest rate futures.
No. of Contracts = ×
€ , ,
= × = 2000 Contracts
€ ,
The final outcome in the given two scenarios shall be as follows:
If the interest rate turns out to be If the interest rate turns out to be
4.5% 6.5%
Future Course Action:
Sell to open 94.15 94.15
Buy to close 95.50 (100 - 4.5) 93.50 (100 - 6.5)
Loss/ (Gain) 1.35% (0.65%)
Cash Payment (Receipt) €50,000×2000× 1.35%×3/12 €50,000×2000×0.65%×3/12
for Future Settlement = €337,500 = (€162,500)
Interest for 6 months on €50 million × 4.5% × ½ €50 million × 6.5% × ½
€50 million at actual rates = €11,25,000 = €16,25,000
€1,462,500 €1,462,500
€ , ,
Thus, the firm locked itself in interest rate x 100 x = 5.85%
€ , ,
 9.3

SOLUTION 1E
(i) DEF Bank will fix interest rate for 2V3 FRA after 2 years as follows:
XYZ Ltd.
(1 + 𝑟) (1 + 0.0420) = (1 + 0.0448)
(1 + 𝑟) (1.0420) = (1.0448)
r = 5.04%
Bank will quote 5.04% for a 2V3 FRA. ABC Ltd.
(1 + 𝑟) (1 + 0.0548) = (1 + 0.0578)
(1 + 𝑟) (1.0548) = (1 + 0.0578)
r = 6.38%
Bank will quote 6.38% for a 2V3 FRA.
(ii)
4.50%- Allow to Lapse 5.50%-Exercise
Interest ₹ 100 crores X 4.50% ₹ 4.50 crores -
₹ 100 crores X 5.04% - ₹ 5.04 crores
Premium (Cost of Option) ₹ 100 crores X 0.1% ₹ 0.10 crores ₹ 0.10 crores
4.60 crores 5.14 crores

SOLUTION 2A
Spot Rate: 1$ = 140 Yen
Year End
1 1$ = 135 Yen
2 1$ = 130 Yen
3 1$ = 125 Yen
4 1$ = 120 Yen
a) Payment received by Yasufuku after 4 year
In 70 million ( 1 + 0.10)4 = 102.487 million
In $ (Equivalent Dollars)
.
= million = $ 854058
Hint 1 $ = 120
b) Payment received by Mc. Donald after 4 Year
5,00,000 × $ (1 + 0.13)4 = $ 8,15,236.80
c) Yasufuku is in a better position than Mc. Donald. This is because Yasufuku is receiving more dollars than Mc.
Donald after 4 years.
If Yen do not change in value
Amount received by Yasufuku ($) = 102.487 × million = $ 7,32,050
Amount received by Mc. Donald ($) = $ 8,15,236.80
If Yen did not change in value, Mc. Donald will be in a better position.
Additional Analysis:
$ 5,00,000 = Yen 70 million
1 $ = 140 Yen
SOLUTION 2B

Opportunity gain of A Inc under currency swap Receipt Payment Net

Interest to be remitted to B. Inc in
$ 2,00,000х9%=$18,000 ¥21,60,000
Converted into ($18,000х¥120)
Interest to be received from B. Inc in $ ¥14,40,000 -
converted into Y (6%х$2,00,000 х ¥120)
Interest payable on Y loan - ¥12,00,000
¥14,40,000 ¥33,60,000
 9.4 INTEREST RATE RISK MANAGEMENT

Net Payment ¥19,20,000 -

¥33,60,000 ¥33,60,000
$ equivalent paid ¥19,20,000 х(1/¥120) $16,000
Interest payable without swap in $ $18,000
Opportunity gain in $ $ 2,000
Opportunity gain of B inc under currency swap Receipt Payment Net
Interest to be remitted to A. Inc in ($ 2,00,000 х 6%) $12,000
Interest to be received from A. Inc in Y converted into $18,000
$ =¥21,60,000/¥120
Interest payable on $ loan@10% - $20,000

$18,000 $32,000
Net Payment $14,000 -

$32,000 $32,000
Y equivalent paid $14,000 X ¥120 ¥16,80,000
Interest payable without swap in ¥ ($2,00,000X¥120X8%) ¥19,20,000
Opportunity gain in Y ¥ 2,40,000
Alternative Solution
Cash Flows of A Inc
(i) At the time of exchange of principal amount
Transactions Cash Flows
Borrowings $2,00,000 x ¥120 + ¥240,00,000
Swap - ¥240,00,000
Swap +$2,00,000
Net Amount +$2,00,000
(ii) At the time of exchange of principal amount
Transactions Cash Flows
Interest to the lender ¥240,00,000X5% ¥12,00,000
Interest Receipt from B Inc. ¥2,00,000X120X6% ¥14,40,000
Net Saving (in $) ¥2,40,000/¥120 $2,000
Interest to B Inc. $2,00,000X9% -$18,000
Net Interest Cost -$16,000
A Inc. used $2,00,000 at the net cost of borrowing of $16,000 i.e. 8%. If it had not opted for swap agreement
the borrowing cost would have been 9%. Thus there is saving of 1%.
Cash Flows of B Inc
(i) At the time of exchange of principal amount
Transactions Cash Flows
Borrowings + $2,00,000
Swap - $2,00,000
Swap $2,00,000X¥120 +¥240,00,000
Net Amount +¥240,00,000
(ii) At the time of exchange of principal amount
Transactions Cash Flows
Interest to the lender $2,00,000X10% - $20,000
Interest Receipt from A Inc. +$18,000
Net Saving (in ¥) -$2,000X¥120 - ¥2,40,000
Interest to A Inc. $2,00,000X6%X¥120 - ¥14,40,000
Net Interest Cost - ¥16,80,000
 9.5

B Inc. used ¥240,00,000 at the net cost of borrowing of ¥16,80,000 i.e. 7%. If it had not opted
for swap agreement the borrowing cost would have been 8%. Thus there is saving of 1%.
SOLUION 3A
(i) Semi-annual fixed payment
= (N) (AIC) (Period)
Where N = Notional Principal amount = ₹5,00,000
AIC = All-in-cost = 8% = 0.08
= 5,00,000 × 0.08
= 5,00,000 × 0.08 (0.5)
= 5,00,000 × 0.04 = ₹20,000/-
(ii) Floating Rate Payment
= N (LIBOR)
= 5,00,000 × 0.06 ×
= 5,00,000 × 0.06 (0.503) or 5,00,000 × 0.06 (0.502777)
= 5,00,000 × 0.03018 or 0.30166 = ₹15,090 or 15,083
Both are correct
(iii) Net Amount
= (i) – (ii)
= ₹20,000 – ₹15,090 = ₹4,910
or = ₹20,000 – ₹15,083 = ₹4,917
SOLUTION 3B

Day Principal (₹) MIBOR (%) Interest (₹)

Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Note: Alternatively, answer can also be calculated on the basis of 360 days in a year.
SOLUTION 4A
(a) There is no payoff to the cap if the cap rate exceeds 3-month MIBOR. For Periods 2 and 3, there is no payoff
because 3-month MIBOR is below the cap rate.
For Periods 1 and 4, there is a payoff and the payoff is determined by:
100 crore x (3-month MIBOR - Cap Rate)/4
The payoffs are summarized below:
Quarters 3-months MIBOR (%) Pay-off (₹)
1 8.70 17,50,000
2 8.00 Nil
3 7.80 Nil
4 8.20 5,00,000
(b) There is no payoff to the floor if the 3-months MIBOR exceeds Floor rate. For Periods 1 and 2, there is no payoff
because 3-month MIBOR is above the floor rate.
For Periods 3 and 4, there is a payoff and the payoff is determined by:
100 crore x (Floor rate - 3-month MIBOR )/4
 9.6 INTEREST RATE RISK MANAGEMENT
The payoffs are summarized below:
Quarters 3-months MIBOR (%) Pay-off (₹)
1 4.70 Nil
2 4.40 Nil
3 3.80 10,00,000
4 3.40 30,00,000
SOLUTION 4B
First of all we shall calculate premium payable to bank as follows:
P= × A or ×A
( ÷ ) ( . %, )
×( )
Where
P = Premium
A = Principal Amount rp = Rate of Premium
i = Fixed Rate of Interest
t = Time
. .
= × £15,000,000 or × £15,000,000
( / . ) ( . . . . )
. × .

. £ ,
= × £15,000,000 or = £ 40,861
( . ) .
.
Please note above solution has been worked out on the basis of four decimal points at each stage.
Now we see the net payment received from bank
Reset Period Additional interest due Amount Premium paid to Net Amt. received
to rise in interest rate received from bank from bank
bank
1 £ 75,000 £ 75,000 £ 40,861 £34,139
2 £ 112,500 £ 112,500 £ 40,861 £71,639
3 £ 150,000 £ 150,000 £ 40,861 £109,139
TOTAL £ 337,500 £ 337,500 £122,583 £ 214,917
Thus, from above it can be seen that interest rate risk amount of £ 337,500 reduced by £ 214,917 by using of Cap
option.
Note: It may be possible that student may compute upto three decimal points or may use different basis. In such
case their answer is likely to be different.
SOLUTION 4C
(a) 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
}
Floor Pay-off
Max {0, [Notional principal x (Floor Strike Rate – LIBOR on Reset date) x }
Statement showing effective interest on each re-set date
Reset Date LIBOR Days Interest Cap Floor Pay- Effective Interest
(%) Payment ($) Receipts off
LIBOR+0.50% ($) ($)
31-12-2013 6.00 184 3,27,671 0 0 3,27,671
30-06-2014 7.50 181 3,96,712 24,795 0 3,71,917
31-12-2014 5.00 184 2,77,260 0 0 2,77,260
30-06-2015 4.00 181 1,98,356 0 0 1,98,356
31-12-2015 3.75 184 1,89,041 0 12,603 2,01,644
30-06-2016 4.25 182 2,36,849 0 0 2,36,849
Total 1096 16,26,094
 9.7

(b) Average Annual Effective Interest Rate shall be computed as follows:

, ,
× ×100 = 5.42%
, , ,

SOLUTION 4D
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 : ₹ 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 ₹ 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/- (₹ 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. The compensation received by the buyer of caps will be as follows:
On 31st March 2013
The buyer of the caps will receive the compensation at the rate of 1.70% (10.20 - 8.50) to be calculated on ₹
40,00,000, the amount of compensation will be ₹ 68000/- (40,00,000 x 1.70/100)
On 31st March 2014
The buyer of the caps will receive the compensation at the rate of 3.00% (11.50 – 8.50) to be calculated on ₹
40,00,000/-, the amount of compensation will be ₹ 120000/- (40,00,000 x 3.00/100).
On 31st March 2015
The buyer of the caps will receive the compensation at the rate of 0.75% (9.25 – 8.50) to be calculated on ₹
40,00,000/-, the amount of compensation will be ₹ 30,000 (40,00,000 x 0.75/100).
On 31st March 2016
The buyer of the caps will not receive the compensation as the actual rate of interest is 8.25% whereas strike rate
of caps is 8.5%. Hence, his interest liability shall not exceed 8.50%.
Thus, by paying the premium upfront buyer of the caps gets the compensation on the respective interest due dates
without any obligations.