CA-FINAL

SFM
IRS, CAPS,
FLOOR, FRA
RAJESH RITOLIA, FCA
HELPING HAND INSTITUTE
G-80, 2ND FLOOR, GUPTA COMPLEX, LAXMI NAGAR, DELHI-92
PH: 9350171263, 9910071263
Email: [email protected]; Web: correctingmyself.in

Note:
(a) Video CD of missing classes will be provided free of cost
(b) Updated notes can be downloaded free of cost from our website: correctingmyself.in
(c) Updated classes can be covered in future at free of cost
(d) Notes also cover Suggested, RTP

Positive Thoughts
Just be yourself, utterly yourself. And don’t be bothered about what kind of flower you
turn out to be. It does not matter whether you are a rose or a lotus or a marigold, what
matters is flowering.
Earth provides enough to satisfy every man’s needs, but not every man’s greed.
Nature does not hurry, yet everything is accomplished.
Whenever you find me wrong, bad or rude at any point of time, at least tell me once
before telling the whole world
We can save many relations, If we understand as simple fact that people are not wrong.
They are different.
Judging a person does not define who they are. It defines who you are
 IRS, CAPS, FLOOR, COLLAR & FRA

THEORY

4
3.5
3
2.5
2
T
1.5
1
0.5
0
M11 N11 M12 N12 M13 N13 M14 N14 M15 N15

PRACTICAL

14
12
10
8
6 P

4
2
0
M11 N11 M12 N12 M13 N13 M14 N14 M15 N15
Chap – 11D SUMMARY OF IRS, CAPS, FLOOR, COLLAR, FRA 11DA.1
11D.0 Technical Terms
11D.0.1 MIBOR

Mumbai Interbank Offered Rate

The interest rate at which banks can borrow funds, in marketable size, from other banks in the Indian interbank market.
MIBOR is calculated everyday by the National Stock Exchange of India (NSEIL) as a weighted average of lending rates of
a group of banks, on funds lent to first-class borrowers.

The MIBOR was launched on June 15, 1998 by the Committee for the Development of the Debt Market, as an overnight
rate. The NSEIL launched the 14-day MIBOR on November 10, 1998, and the one month and three month MIBORs on
December 1, 1998. Since the launch, MIBOR rates have been used as benchmark rates for the majority of money
market deals made in India.

11D.0.2 LIBOR
London Interbank Offered Rate

It serves as the first step to calculating interest rates on various loans throughout the world for short term.

LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar
(USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF), and serves seven different
maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There are a total of 35 different LIBOR rates each
business day. The most commonly quoted rate is the three-month U.S. dollar rate

11D.0.3 PLR

Prime lending rate

It is charged by banks to their largest, most secure and most credit worthy customers on short term loan.

This rate is used as guide for computing interest rates for other borrowers

11D.1 Interest Rate Swaps

[Nov-2008-O-3cii-04] Write short notes on Interest Rate Swaps.
[May-2012-7b-04] Write short notes on Interest Swaps.

(a) An Interest Rate Swap is a transaction involving an exchange of one stream of interest obligations for another.
In an interest rate swap, no exchange of principal takes place but interest payments are made on the notional
principal amount.
The method of calculating the payments is agreed at the beginning of transaction.
The parties to the agreement, termed the swap counterparties, agree to exchange payments indexed to two
different interest rates.

(b) Financial intermediaries, such as banks, pension funds, and insurance companies, as well as non-financial firms use
interest rate swaps to effectively change the maturity of outstanding debt or that of an interest-bearing asset.

(c) Uses of Interest rate swap

(i) Reduces cost of new borrowing

(ii) Fixed rate borrowing/Deposit can be converted into Floating rate borrowing/Deposit

(iii) Floating to Fixed rate

(iv) LIBOR to PLR

(v) PLR to LIBOR

(d) An interest rate swap arrangement are an off balance sheet items, as the principal amount is not swaped.

(e) Features of Interest rate swaps

It is treated as an off - the balance sheet transaction.

It is structured as a separate contract distinct from the underlying loan agreement.
There is no exchange of principal repayment obligations.
It effectively translates a floating rate borrowing into a fixed rate borrowing and vice versa.
The motivation of interest rate swap is to save interest cost.

(f) Type of Interest rate Swap

Liability Swap : Where there is an exchange of interest obligation i.e., interest is to be paid, the swap is liability
swap.
Asset Swap : Where there is an exchange of interest receipts i.e., interest is to be received, the swap is asset swap.
Chap – 11D SUMMARY OF IRS, CAPS, FLOOR, COLLAR, FRA 11DA.2
11D.2 How Cost of New loan can be reduced through IRSA [Q-1 to 3]

(a) Following are Step for reduction of Interest rate

(i) Calculate total Interest of both party as per their preferences [Before Swaping]

(ii) Calculate total Interest of both party after Swaping

(iii) Saving of Interest = Diff of (i) – (ii)

Distribute Savings between parties as per Question

Net Interest rate to each party = Interest rate as per their preferences – Savings

11D.2.1 Interest rate swap between 3 parties [Q-3]

11D.3 Existing Loan/Deposit to be converted from Fixed to Floating or Vice Versa through IRS [Hedging] [Q-
4 to 7]
ICAI RTP
May-2010-5a-10 Nov-2015-3

Process for converting obligation of Loan

Existing loan Under Swap Arrangement Net Interest

Fixed Rate Payable Fixed Rate Receivable Floating Rate Payable Floating Rate Payable

Fixed Rate Receivable Fixed Rate Payable Floating Rate Receivable Floating Rate receivable

Floating Rate Payable Floating Rate Receivable Fixed Rate Payable Fixed Rate Payable

Floating Rate Receivable Floating Rate Payable Fixed Rate Receivable Fixed Rate receivable

11D.3.1 Existing Loan to be converted from Fixed to Floating [Q-4]

11D.3.2 Existing Loan to be converted from Floating to Fixed [Q-5 to 7]

11D.4 IRS for Speculative Transaction [Q-8 to 9]

ICAI RTP
Nov-2008-1b-3 May-2015-18
Nov-2010-3b-8 May-2014-6
Nov-2010-2a-8

(a) If IRS is used for speculative transaction, then only gain/(loss) will be calculated as follows:

Gain/(Loss) (Amt) = Interest under Fixed rate – Interest under floating rate

(b) Principal amt is not inter changed under swap agreement

(c) If Question ask about calculation of gain/loss in terms of rate

Gain/(Loss) = Fixed Interest rate – floating Interest rate

(d) Floating rate remains same before holiday to holiday

11D.5 Caps, Floor and Collar [Q-10 to 16]

ICAI RTP
May-2013-1d-5 Nov-2011-3a
Nov-2012-3b
May-2013-7b
May-2013-7a
May-2014-4

[May-2002] [M-2] Distinguish between Caps and Collars.

[May-2015-7d-4] [Nov-2010-7c-4] Give the meaning of ‘Caps, Floors and Collars’ options with respect to interest
rate
11D.5.1 Interest Rate Caps [Q-10 to 13]
Chap – 11D SUMMARY OF IRS, CAPS, FLOOR, COLLAR, FRA 11DA.3
(a) An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the
interest rate exceeds the agreed strike price.
It is traded over the counter (it is not traded in any exchange)
Purchase of a cap enables borrowers to fix maximum borrowing rate for a specified amount and for a specified
duration, while allowing him to avail benefit of a fall in interest rates.

(b) It is useful for those who borrow money on the basis of floating rate.

(c) It is a type of European Call Option and for this buyer is required to pay premium.

(d) Uses of Cap for Speculative Transaction

In this case there will be no actual borrowing and cap is purchased only for speculative profit

Gain/Loss on Caps = [Max(Current market rate - Cap Rate)]*Principal*(No. of days to maturity/360)

Gain/(Loss) = Gain/(Loss) on settlement of Cap +- Premium Paid

(e) Uses of Cap for Hedging

If actual borrowing is taken at floating rate and borrower has apprehension that interest may increase in future he
may purchase cap for hedging.

Net cost of loan = Interest payable on borrowing – Gain on settlement of Cap + Premium Paid

(f) Buyer receives payments at the end of each period in which the interest rate exceeds strike price

11D.5.2 Floor [Q-14 to 15]

(a) An interest rate floor is a derivative in which buyer of the floor receives money if on the maturity, the interest rate
is below the agreed strike price of the floor.
It is traded over the counter (it is not traded in any exchange)
Purchase of a Floor enables a lender to fix in advance, a minimum rate of placing a specified duration, while
allowing him to avail benefit of a rise in rates.

(b) It is useful for those who deposit money on the basis of floating rate.

(c) It is a type of European Put Option and for this buyer is required to pay premium.

Uses of Floor for Speculative Transaction

In this case there will be no actual borrowing and Floor is purchased only for speculative profit

Gain/Loss on Floor = [Max(Floor Rate - Current market rate)]*Principal*(No. of days to maturity/360)

(d) Uses of Floor for Hedging

If actual deposit is taken at floating rate and depositor has apprehension that interest may decrease in future he
may purchase floor for hedging.

Net Interest of Deposit = Interest receivable on deposit + Gain on settlement of Floor - Premium Paid

Buyer receives payments at the end of each period in which the interest rate exceeds strike price

11D.5.3 Collar [Q-16]

(a) Collar is a combination of cap and floor.

The purchaser of a collar buys a cap and simultaneously sells a Floor. A Collar has the effect of locking its purchases
into a floating rate of interest that is bounded on both high side and the low side.
The collar seller undertakes to compensate the loss of collar buyer (on account of change in interest rate) and
Option buyer agrees to share with him the profit he will have (on account of change in interest rate).

(b) Purchaser of Collar will be holder of Caps and writer of Floor

(c) The cap rate is set above the floor rate.

(d) The objective of the buyer of a collar is to protect against rising interest rates (while agreeing to give up some of
the benefit from lower interest rates).
The purchase of the cap protects against rising rates while the sale of the floor generates premium income.

11D.6 A Forward Rate Agreement (FRA) [OTC] [Q-17 to 22]

ICAI RTP
May-2010-5b-8 Nov-2012-6
May-2013-6b-8 May-2014-5
Nov-2014-1
Chap – 11D SUMMARY OF IRS, CAPS, FLOOR, COLLAR, FRA 11DA.4
(a) A forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a
floating interest rate and vice versa.

(b) On this type of agreement, it is only the differential that is paid on the notional amount of the contract.

(c) It is paid on the effective date.

(d) There are no flows of the principal amounts

(e) FRAs are over-the counter derivatives. A FRA differs from a swap in that a payment is only made once at maturity.

(f) Reference Date

The agreement is executed on the basis of the interest rate prevailing in the market (this rate is known as the
reference rate) two days before the date on which the borrowing or lending is done. For example, if borrowing or
lending is to be done on 1st April,2009, the agreement will be executed on the basis of the interest rate prevailing
on 29th march,2009. This date (i.e.29th March,2009) is referred to as the reference date.

(g) Uses of FRA for Speculative Transaction

Gain/(Loss) on settlement of Transaction = N*(RR-FR)(dtm/360/1+RR (dm/360)
N (RR-FR)(dtm/360/1+RR(dm/360)
Where
N=National Principal Amount
RR =Reference Rate
FR =Agreed upon Forward Rate
Dtm=FRA period specified in days.
(h) Uses of FRA for Hedging
The buyer (borrower) is the party seeking to protect itself against a rise in interest rates.
The seller (lender) is the party seeking to protect itself against a fall in interest rates.

(i) How it is Quoted : FRAs are quoted in the format A x B, with (A) representing the number of months until the loan
is set to begin, and (B) representing the number of months until the loan ends. To find the length of the loan,
subtract A from B.
[3x9 - 3.25/3.50%p.a ] - means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing
interest rate starting 3 months from now for 6 month is 3.50%.

FRA – Purchase – Pay – Fixed Rate and Receive – Reference rate

FRA – sell – Receive – Fixed Rate and Pay – Reference rate

11D.6.3 Expectation Theory for calculation of Forward Rate [Q-21 to 22]

(a) Forward rate is the interest rate that we expect today to prevail in the market after certain period.

(b) Forward rate for the first year is the rate of interest that we expect, in the beginning of the first year to earn on
our investment made in the beginning of the 1st year till the end of the first year. It is also referred as spot rate for
1st year.

(c) Forward rate for the Second year is the rate of interest that we expect today, to earn on our investment made in
the beginning of the 2nd year till the end of the 2nd year.
And so on.

(d) Calculation of Forward rate for the first year

(1 + YTM) = (1 + FR)
First year YTM and Forward rate is equal

(e) Calculation of forward rate for Second Year

(1+YTM)2 = (1+FR1)(1+FR2)

(f) Calculation of forward rate for third Year

(1+YTM)3 = (1+FR1)(1+FR2) (1+FR3) OR
(1+YTM)3 = (1+YTM2 year)2(1+FR3)

Forward rate can be determined as follows: [Covered in BV]

(1+IR1-3)(1+FR4-6) = (1+IR1-6)
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.1
11D.2 How Cost of New loan can be reduced through IRSA [Q-1 to 3]
Question-1 Company ABC and XYZ have been offered the following rate per annum on a Rs.200 million five
year loan:
Fixed Rate Floating Rate
Company ABC 12.0 LIBOR + 0.1 %
Company XYZ 13.4 LIB OR + 0.6%
Company ABC requires a floating-rate loan and XYZ require Fixed rate funding. Design a swap that will net a
bank acting as intermediary at 0.1 % per annum and be equally attractive to both the companies.

Question-1A Companies A and B are interested in raising loans. The financiers have quoted the following
interest rates:
Fixed Floating
A 11 % LIBOR + 0.25%
B 12.50% LIBOR + 0.40%
A is interested in floating, B is interested in fixed. A financial institution is planning to arrange a swap and
requires a 35 basis point spread. If the swap is equally attractive to A and B, what rates of interest will A
and B end up paying?

Question-2 [SP] Company B intends to raise a loan of $10m. At the same time Company A intends to
raise a loan of £5m. 1£ = 2$. The lenders have submitted the following quotations:
Company A Company B
USD Interest Rate 8.00% 9.50%
GBP Interest Rate 5.00% 5.30%
Draw a swap which would be equally attractive to all the three parties i.e. A, B and intermediary.
Assume no change in foreign exchange rate.

11D.2.1 Interest rate swap between 3 parties

Question-3 A, B and C are three companies, which are not finding suitable interest rates offered for their
funds requirement, have approached a bank for arranging interest rate swap.
Company A B C
Objective Fixed Rate (%) T-bill rate based funds (%) PLR based funds (%)
Fixed rate 14 12 15
T -bill rate based funds T -bill +4 T -bill + 3 T -bill + 5
PLR based funds PLR + 2 PLR + 3 PLR + 4
The bank wants to arrange swaps between the three parties in such a way so that it can retain 25% of the
total gain. The rest of the gain is to be distributed equally among the three parties.
You are required to show how the bank will structure the swap.

Question-3A [SP] M Ltd., K Ltd and D Ltd. are planning to raise a loan of Rs.10m each. M is
interested on fixed rate basis, K on MIBOR based floating rate and D on Treasury based floating
rate. They have been offered the loans on the following basis:
M K D
FIXED RATE 6% 7% 8%
MIBOR BASED RATE M +1 M +3 M+4
T.BILL BASED RATE T+3 T +5 T +5
An intermediary brings them to the table and an interest swap is arranged. The intermediary
takes 0.10 of total savings as its commission and balance i.e. 0.90 is shared equally by M, K and
D.
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.2
11D.3 Existing Loan/Deposit to be converted from Fixed to Floating or Vice Versa through IRS
[Hedging] [Q-4 to 7]
ICAI RTP
May-2010-5a-10 Nov-2015-3

11D.3.1 Existing Loan to be converted from Fixed to Floating

Question-4 On 1st Jan, 2007, a nationalized bank issued 14% 9 years’ maturity debentures.
It is 1st January, 2008. The interest rates have declined substantially. 8 years maturity Government
securities are being traded in the market on the basis of 10% YTM; 364 days t-bills are quoted at 10.50%.
The bank apprehends further decline in interest rates and hence, is interested in converting the fixed
interest rate obligation into floating rate obligation.
The t- bill rates are expected to decline 25bp during the current year then rise by 5bp every year thereafter.
A financial institution (FI) has submitted the quotation of fixed to floating rate swap as T-bill rate
v/s60/70bp over 8 years Government securities YTM. Advice

11D.3.2 Existing Loan to be converted from Floating to Fixed

Question-5 On 1st Jan,2007, a Nationalized Bank (NB) issued Rs.100m 9 years’ maturity debentures at a
floating of MIBOR +2% interest payable at six month intervals.
It is 1st January, 2009. The interest rates have gone up substantially, the bank apprehends further upward
trend in interest rates and hence, is interested in converting the floating interest rate obligation into fixed
rate obligation. A financial Institution (FI) has submitted the quotation of fixed to floating rate swap as
MIBOR v/s 10.25-10.40, interest payments semi-annuals. Advise.

Question-6 [RTP-Nov-2015-3] Bank offers a variety of services. Bank is also in the business of acting as
intermediary for interest rate swaps.
Sleepless approaches Bank who have already have Rs.50 cr outstanding and paying interest rate @ PLR +
0.8% p.a. The duration of the loan left is 4 years. Since Sleepless is expecting increase in PLR in coming
year, he asked Bank for arrangement of interest of IRS that will give a fixed rate of interest.
As per the terms of agreement of swap Bank will borrow Rs.50 cr from Sleepless at PLR+0.8% p.a. and will
lend Rs.50 cr 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 Bank will charge commission @ 0.2% p.a. of the loan amount. The
present PLR is 8.2%
You as financial consultant of Bank have been asked to carry out scenario analysis of this arrangement.
Three possible scenarios of interest rate 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

Assume that cost of capital is 10%, whether this arrangement should be accepted or not.

Question-7 [May-2010-O-5a-10] ABC Bank is seeking fixed rate funding. It is able to finance at a cost of
six months LIBOR + ¼% for Rs.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 years.
(a) What will be the “all in cost” funds to ABC Bank?
(b) Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for first three
years and LIBOR + ¼% for remaining two years. Given a three year swap rate of 8%.
(c) Suggest the method by which the bank should achieve fixed rate funding.

11D.4 IRS for Speculative Transaction [Q-8 to 9]

ICAI RTP
Nov-2008-1b-3 May-2015-18
Nov-2010-3b-8 May-2014-6
Nov-2010-2a-8
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.3
Question-8 [Nov-2008-1b-3] Suppose a dealer quotes all in cost for a generic swap at 8% against six
month Libor flat if the notional principal amount of swap is Rs. 5,00,000
(a) Calculate semi annual fixed payment.
(b) Find the first floating rate payment for (a) 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.
(c) In (b) 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.

Question-8A [Nov-2010-3b-8] [SP] 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 Rs.6,00,000.
(a) Calculate semi annual fixed payment.
(b) Find the first floating rate payment for (a) above, it 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.
(c) In (b) 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.

Question-9 [Nov-2010-2a-8] [RTP-May-2014-6] [RTP-May-2012-18] Derivative Bank entered into a

plain vanilla swap through on OIS [Overnight Index Swap] 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,
2nd August, 2010 and was to commence on 3rd 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%
If Derivatives Bank received 317 net on settlement, calculate Fixed Rate Interest under both legs.
Notes:
(a) Sunday is Holiday.
(b) Work is rounded rupees and avoid decimal working.

11D.5 Caps, Floor and Collar [Q-10 to 16]

ICAI RTP
May-2013-1d-5 Nov-2011-3a
Nov-2012-3b
May-2013-7b
May-2013-7a
May-2014-4

11D.5.1 Interest Rate Caps

Question-10 X Ltd Borrows money on the basis of Mibor + 0.50 and buys cap at 8%
Mibor at that time say 8%
Suppose MIBOR at the end of year are 12%, 9%, 8%, 7%, 6%
How buyer of cap is benefited from it.

Question-11 A Company borrows £ 1 billion at a floating rate of Libor + 0.60% for 1 year, interest payable
at the end of the year. The company apprehends that LIBOR may rise and hence, it is considering to hedge
the interest rate. The company buys a cap at 6.5% for a premium of 1.15% per year. Calculate the effective
interest rates assuming the LIBOR rate for next year is (i) 4.7%; (ii) 5.8% (iii) 7.3%.

Question-12 [RTP-Nov-2012-3a] [RTP-May-2013-7a] Suppose that a 1-year cap has cap rate of 8%
and a notional amount of Rs.100 Crore. The frequency of settlement is quarterly and the reference rate is 3-
month MIBOR. Assume that 3-month MIBOR for the next four quarters is as shown below.
Quarters 3-monhts MIBOR (%)
1 8.70
2 8.00
3 7.80
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.4
4 8.20
You are required to compute payoff for each quarter.

Question-13 [May-2013-1d-5] XYZ Ltd borrows £ 15 m for six months Libor + 1% 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%. The lump sum premium is 1% for the entire reset periods and the fixed rate of
interest is 7% p.a. The actual position of Libor during the forthcoming reset period is as under:
Reset Period Libor
1 9%
2 9.50%
3 10%
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.

11D.5.2 Floor

Question-14 X Ltd deposit money on the basis of Mibor + 0.75 and buys Floor at 7%
Mibor at that time say 8%
Suppose MIBOR at the end of year are 12%, 9%, 8%, 7%, 6%
How buyer of floor is benefited from it.

Question-15 [RTP-May-2013-7b] [RTP-Nov-2012-3b] Suppose that a 1-year floor has a rate of 4%

and a notional amount of Rs.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 quarters is as shown below.
Quarters 3-monhts IBOR (%)
1 4.70
2 4.40
3 3.80
4 3.40
You are required to compute payoff each quarter.

11D.5.3 Collar
Question-16 [RTP-May-2014-4] XYZ inc. issue a £10 million floating rate loan on July 1,2013 with
resetting of coupon rate every 6 months equal to LIBOR+ 50bp. 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
July1,2013.
Notional Principal Amount $10 Million
Reference Rate 6 months 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 reset date,
(ii) The average overall effective rate of interest p.a.
Reset Date LIBOR(%)
31-12-2013 6.00
30-06-2014 7.50
31-12-2014 5.00
30-06-2015 4.75
31-12-2015 3.75
30-06-2016 4.25
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.5
11D.6 A Forward Rate Agreement (FRA) [OTC] [Q-17 to 22]
ICAI RTP
May-2010-5b-8 Nov-2012-6
May-2013-6b-8 May-2014-5
Nov-2014-1

Question-17 Today is 1st April 2007. A Ltd. is to receive Rs.10,00,000 on 1st July,2007. This amount will be
surplus with term for six months. They plan to invest this amount on the date of its receipt for six months
period. Suppose today this amount can be invested either at fixed interest of 10% p.a. or at floating rate of
MIBBOR +1%. They apprehend decline in the interest rate in coming period and hence are interested in
investing on fixed interest basis. They estimate that the fixed rate may decline by the date of their actual
investment (i.e. 1st July,2007). How A Ltd can hedge risk of reduction of interest rate.

Question-18 Suppose today is 1st April 2007. A Ltd. is to borrow Rs.10,00,000 on 1st July,2007 for a period
of 1 year. A Ltd. apprehends that the interest rates may go up by time it will borrow. At present the interest
applicable to the borrowings of one year is 9.75% p.a. How A Ltd can hedge risk of increase in interest rate.

Question-18A Suppose today is 1st April,2007. A Ltd. is to invest Rs.10,00,000 on 1st July,2007 for a
period of 1 year. A Ltd. apprehends that the interest rates may decline by the time it will invest. At present
the interest applicable to the investment for 1 year is 9.75% p.a. A Ltd. approaches a bank for an FRA. The
bank quotes the rate of 9.50% p.a. The parties enter into an FRA on the basis of (i) the facts given in this
question and (ii) the rate quoted by the bank. On reference date, the interest rate prevailing in the market
is 9.00.
(a) Explain the execution of the FRA.
(b) What amount will be received by A Ltd. on 1st July,2007?
(c) What amount will be received by A Ltd. on 1st July,2008?

Question-18B A company is to invest Euro 1 m for period of three months from today. It enters into a
‘24×27’ FRA with agreed interest rate of 5%. After 24 months the 3 months interest is 5.50%. Explain the
cash flow on account of the FRA.
(a) What amount will be invested by the company for a period of three months after 24 months from today?
(b) What amount will be received by company after 27 months from today?

Question-19 [May-2013-6b-8] M/s. Parker & Co. is contemplating to borrow an amount of Rs.60 crores
for a period of 3 months in the coming 6 months time from now. The current rate of interest is 9% p.a. 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 9.30% p.a.
What will be the effect of FRA and actual rate of interest cost to the company, it the actual rate of interest
after 6 months happens to be 9.60% p.a. and ii) 8.80% p.a.?

Question-19A [RTP-Nov-2012-6] TM Fincorp has bought a 6x9 Rs.100 crore Forward Rate Agreement
(FRA) at 5.25%. On fixing date reference rate i.e. MIBOR turnout 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 amount.
(Assume 360 days in a year)

Question-20 [RTP-May-2014-5] 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.
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.6
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 months €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 interest rate after 6 months turnout to be:
(i) 4.5% (ii) 6.5%
(b) How 3 months Future contract shall be useful for company if interest rate turnout as mentioned in part
(a) above.

11D.6.3 Expectation Theory for calculation of Forward Rate

Question-21 [May-2010-5b-8] The following market data is available:

Spot USD/ JPY 116.00
Deposit rate p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward rate agreement for YEN is nil.
(a) What should be 3 months FRA rate at 3 months forward?
(b) The 6 & 12 months 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 case.

Question-22 [RTP-N-2014-1] ABC Ltd. and XYZ Ltd. approach the DEF Bank FOR FRA (Forward Rate
Agreement). They want to borrow a sum of Rs 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 required
to calculate the interest payable by XYZ Ltd. if interest in 2 years turns out to be
(a) 4.50%
(b) 5.50%

11D.7 Theory
Question-1 [May-2010-5b-4] What do you know about swaptions and thier uses?
Solution
Swaption is are combination of the features of two derivative instruments i.e. option and swap.
A swaption is an option on an interest rate swap. The option buyer pays up front premium and in return
gets a right but not the obligation to enter into an interest swap agreement on a specific future date.
Swaptions are traded over the counter, for both short and long maturity expiry dates, and for wide range of
swap maturities.
The price of a swaption depends on the strike rate maturity of the option and expectations about the future
volatility of swap rates.
The swaption premium is expressed as basis points

Question-2 [Nov-2008-O-3cii-04] Write short notes on Interest Rate Swaps.

[May-2012-7b-04] Write short notes on Interest Swaps.
Solution – Covered in Summary
Chap – 11D IRS, CAPS, FLOOR, FRA 11DB.7
Question-3 [May-2002] [M-2] Distinguish between Caps and Collars.
[May-2015-7d-4] [Nov-2010-7c-4] Give the meaning of ‘Caps, Floors and Collars’ options with respect
to interest rate
Solution-Covered in Summary

Question-4 Types of Swap

Plain Vanilla Swaps
These are fixed-to-floating interest rate swaps between two parties in which each contracts to make
payments to the other on particular dates in the future till a specified termination date. [In the same
Currency]

Basis rate swaps

These are similar to plain vanilla swaps but in a basis rate swap both legs are floating rate but measured
against different benchmarks.

Amortising swaps:
These are swaps for which the notional principal falls over its term. They are particularly useful for
borrowers who have issued redeemable debt. It enables them to match interest rate hedging with the
redemption profile of the bonds.

Forward swaps:
These are swaps arranged to run from some point in the future. They are similar to FRAs but are longer-
term vehicles.

Currency coupon swap

Which swaps a fixed or floating rate interest payment in one currency for a floating rate payment in
another. These are also known as Circus Swaps.
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.1
Solution-1
Total interest cost of both parties under own choices [Before Swap] = Floating Rate to ABC + Fixed Rate to XYZ
= [Libor + 0.1%] + 13.4% = Libor + 13.5%
Total interest cost of both parties after Swap = Fixed Rate to ABC + Floating Rate to XYZ
= [Libor + 0.6%] + 12% = Libor + 12.6%
Saving in total Cost due to Swap = [Libor + 13.5%] – [Libor + 12.6%] = 0.9%
Distribution of Saving to
Intermediary = 0.1%
ABC = 0.4%
XYZ = 0.4%
Net cost to ABC Ltd [due to Swap] = Floating Rate to ABC – Saving = [Libor + 0.1%] – 0.4% = Libor – 0.3%
Net cost to XYZ Ltd [due to Swap] = Fixed Rate to XYZ – Saving = 13.4% – 0.4% = 13%

Understanding of above Swaping through Journal Entry [Not Part of Answer]

ABC wants Floating Rate Loan from HDFC Bank of Rs.200 m
XYZ wants Fixed Rate loan from HDFC Bank of Rs.200m
Before Interest swap Agreement,
ABC will raise loan at Floating rate = L+0.1%
XYZ will raise loan at Fixed rate = 13.4%
Libor rate for the year 2012 – 8%; 2013 – 9%; 2014 – 10%
In the Books of ABC In the Books of XYZ
Date Amt in m Date Amt in m
01/01/2012 Bank A/c 200.00 01/01/2012 Bank A/c 200.00
To HDFC Loan 200.00 To HDFC Loan 200.00
31/12/2012 Interest A/c 16.20 31/12/2012 Interest A/c 26.80
To Bank 16.20 To Bank 26.80
31/12/2013 Interest A/c 18.20 31/12/2013 Interest A/c 26.80
To Bank 18.20 To Bank 26.80
31/12/2014 Interest A/c 20.20 31/12/2014 Interest A/c 26.80
To Bank 20.20 To Bank 26.80

After Interest swap Agreement between ABC, XYZ and Intermediary

ABC will raise loan from HDFC Bank at Fixed rate = 12%
XYZ will raise loan from HDFC Bank at Floating rate = L + 0.6%
Further ABC, XYZ and Intermediary will enter into Swap Agreement in which any benefit due to swap agreement will be
shared between all the parties as per agreement.
Effects on interest Cost due to above agreement
In the Books of ABC In the Books of XYZ
Date Amt in m Date Amt in m
01/01/2012 Bank A/c 200.00 01/01/2012 Bank A/c 200.00
To HDFC Loan 200.00 To HDFC Loan 200.00
31/12/2012 Interest A/c 24.00 31/12/2012 Interest A/c 17.20
To Bank 24.00 To Bank 17.20
Loss to ABC due to Swap Agreement and it will (24-16.20) Gain to XYZ due to Swap Agreement (26.80-17.20)
be recovered from XYZ = 7.80 = 9.60
31/12/2012 XYZ 7.80 31/12/2012 Interest 7.80
To Interest 7.80 To ABC 7.80
Share of Gain receivable from XYZ Net Gain to XYZ will be shared (9.60-7.80) =
between all parties 1.80
31/12/2012 XYZ 0.80 31/12/2012 Interest A/c 1.0
31/12/2012 To Interest 0.80 To ABC 0.80
To Intermediary 0.20
Net Cost to ABC [24-7.8-0.8] 15.40 Net Cost to XYZ [17.2+7.8+0.8+0.2] 26.00
In Floating term L-0.3% In Fixed Term 13%

Next Year 2013

In the Books of ABC In the Books of XYZ
Date Amt in m Date Amt in m
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.2
31/12/2013 Interest A/c 24.00 31/12/2013 Interest A/c 19.20
To Bank 24.00 To Bank 19.20
Loss to ABC due to Swap Agreement and it will (24-18.20) Gain to XYZ due to Swap Agreement (26.80-19.20)
be recovered from XYZ = 5.80 = 7.60
31/12/2013 XYZ 5.80 31/12/2013 Interest 5.80
To Interest 5.80 To ABC 5.80
Share of Gain receivable from XYZ Net Gain to XYZ will be shared (7.60-5.80) =
between all parties 1.80
31/12/2013 XYZ 0.80 31/12/2013 Interest A/c 1.0
To Interest 0.80 To ABC 0.80
To Intermediary 0.20
Net Cost to ABC [24-5.8-0.8] 17.40 Net Cost to XYZ [19.2+5.8+0.8+0.2] 26.00
In Floating term L-0.3% In Fixed Term 13%

Next Year 2014

In the Books of ABC In the Books of XYZ
Date Amt in m Date Amt in m
31/12/2014 Interest A/c 24.00 31/12/2014 Interest A/c 21.20
To Bank 24.00 To Bank 21.20
Loss to ABC due to Swap Agreement and it will (24-20.20) Gain to XYZ due to Swap Agreement (26.80-21.20)
be recovered from XYZ = 3.80 = 5.60
31/12/2014 XYZ 3.80 31/12/2014 Interest 3.80
To Interest 3.80 To ABC 3.80
Share of Gain receivable from XYZ Net Gain to XYZ will be shared (5.60-3.80) =
between all parties 1.80
31/12/2014 XYZ 0.80 31/12/2014 Interest A/c 1.0
To Interest 0.80 To ABC 0.80
To Intermediary 0.20
Net Cost to ABC [24-3.8-0.8] 19.40 Net Cost to XYZ [21.2+3.8+0.8+0.2] 26.00
In Floating term L-0.3% In Fixed Term 13%

Solution-1A
Total interest cost of both parties under own choices [Before Swap] = Floating Rate to A + Fixed Rate to B
= [Libor + 0.25%] + 12.5% = Libor + 12.75%
Total interest cost of both parties after Swap = Fixed Rate to A + Floating Rate to B
= 11% + [L+0.40] = Libor + 11.40%
Saving in total Cost due to Swap = [Libor + 12.75%] – [Libor + 11.40%] = 1.35%
Distribution of Saving to
Intermediary = 0.35%
ABC = 0.5%
XYZ = 0.5%
Net cost to A [due to Swap] = Floating Rate to A – Saving = [Libor + 0.25%] – 0.5% = Libor – 0.25%
Net cost to B Ltd [due to Swap] = Fixed Rate to B – Saving = 12.5% – 0.5% = 12%

Solution-2
Company B require loan in $, while Company A requires in £
Total Interest rates of both the parties under their Required Currency = USD Rate to B + GBP Rate to A
= 9.50% + 5% = 14.50%
Total Interest rates of both the parties after currency Swap = GBP Rate to B + USD Rate to A
= 5.30% + 8% = 13.30%
Saving in total Cost due to Swap = 14.50% - 13.30% = 1.2%
Distribution of Saving to
Intermediary = 0.4%
ABC = 0.4%
XYZ = 0.4%
Net cost to A [due to Swap] = GBP Rate to A – Saving = 5% – 0.4% = 4.60%
Net cost to B [due to Swap] = USD Rate to B – Saving = 9.50% – 0.4% = 9.10%
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.3
Solution-3
Total interest cost of 3 parties under own choices [Before Swap] = Fixed Rate to A + T-Bill to B + PLR to C
= 14% + T+3% + PLR + 4% = T + PLR + 21%

Process of Swap between three parties

(a) Calculation of difference between maximum & minimum rate under each option
Fixed Rate = 15% – 12% = 3%
T – bill based rate = [T –Bill + 5%] – [T-Bill + 3%] = 2%
PLR Based Rate = [PLR + 4%] – [PLR + 2%] = 2%
Option having maximum difference is selected and party offered lowest rate in selected option will raise loan under that
option.
In our question, B will opt for Fixed Rate at 12%

(b) Calculation of difference between maximum & minimum rate under remaining option
T – bill base d rate = [T –Bill + 5%] – [T-Bill + 4%] = 1%
PLR Based Rate = [PLR + 4%] – [PLR + 2%] = 2%

A will opt for PLR based funds at PLR + 2%

Finally C will opt T-Bill based rate at T-bill + 5%

Total interest cost of 3 parties under after Swap = PLR Rate to A + Fixed to B + T-Bill to C
= [PLR + 2%] + 12% + [T-Bill + 5%] = T + PLR + 19%

Total saving due to Swap = [T-Bill + PLR + 21%] – [T-Bill + PLR + 19%] = 2%
Distribution of Saving to
Intermediary = 0.5%
A = 0.5%
B = 0.5%
C = 0.5%

Net cost to A [due to Swap] = Fixed Rate to A – Saving = 14% – 0.5% = 13.5%
Net cost to B [due to Swap] = T-Bill Rate to B – Saving = [T-Bill + 3%] – 0.5% = T-Bill + 2.5%
Net cost to C [due to Swap] = PLR Rate to C – Saving = [PLR + 4%] – 0.5% = PLR + 3.5%

Solution-3A
Calculation of difference between maximum & minimum rate under each type of interest rate
Fixed = 8 – 6 = 2%
T – bill based rate = T + 5 – T – 3 = 2%
Mibor Based = M + 4 – M – 1 = 3%
The maximum of the three difference be selected and the lower rate under that type shall be taken by the respective
party under that type
In our question M will opt for Mibor Rate M+1

Calculation of difference between maximum & minimum rate under remaining type of interest rate
Fixed = 8 – 7 = 1%
T – bill based rate = T + 5 – Tl – 5 = 0%
K will opt for Fixed based funds under 7%
Finally D will opt T-Bill based rate i.e. Tl + 5
Total rate under Own Choices = 6 + M + 3 + T + 5 = M + T + 14%
Total rate under swaps = M+1 + 7 + T + 5 = M + T + 13%
Total saving = 1%
Net Saving = 1% - .1% = 0.9%
It will be shared equally among party at .5% each
Net cost to M = 6% - 0.3% = 5.7%
Net cost to K = M + 3 – 0.03 = M + 2.7%
Net cost to D = T + 5 – 0.03 = T + 4.7%

Solution-4
Basis point, 100bp =1%
YTM of 8 years Government security = 10% Fixed rate
T bill rate represents floating rate.
Swap Quotation by FI
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.4
Floating Vs Fixed
=T bill rate vs. 0.60 + 8 years Government security YTM
=T bill rate vs.0.60 +10.00 = T bill rate vs.10.60

Existing Loan of Nationalised bank = Fixed = 14%

Floating interest rate is expected to decline in future, hence Bank want to convert Existing loan from Fixed to Floating
rate.
For this, Bank can enter into swap agreement with FI under which Bank will receive Fixed rate and will pay Floating rate.
Under swap, Bank shall get fixed rate (10.60) and shall pay floating i.e. T-bill rate.
Statement showing interest cost under the new arrangement [Existing Loan + Swap Agreement]
Year Existing Interest rate payable Under Swap Arrangement Net Interest Rate Payable by
on bonds by Bank bank[Floating]
Fixed Rate Receivable Floating rate Payable
by Bank by Bank[T Bill]
1 14% -10.60% 10.50% 13.90
2 14% -10.60% 10.25% 13.65
3 14% -10.60% 10.30% 13.70
4 14% -10.60% 10.35% 13.75
5 14% -10.60% 10.40% 13.80
6 14% -10.60% 10.45% 13.85
7 14% -10.60% 10.50% 13.90
8 14% -10.60% 10.55% 13.95
The arrangement results in reduced interest cost and hence, may be implemented.

Solution-5
Existing Loan of NB = Floating payable = M+2%
Floating interest rate are expected to increase in future, hence Bank want to convert Existing loan from floating rate to
Fixed rate.
For this, Bank can enter into swap agreement with FI under which Bank will receive floating rate and will pay Fixed rate.
Swap Quotation by FI
Floating Vs Fixed
=Mibor rate vs. 10.40

Under swap, Bank shall get floating rate at Mibor and shall pay fixed rate 10.40%
Statement showing interest cost under the new arrangement [Existing Loan + Swap Agreement]
Net cost to NB [Annually]
a) Payment to debenture holders [Floating] Mibor + 2
b) Receipt from FI (Under swap) [Floating] - Mibor
c) Payment to FI (Under-annual) [Fixed] 10.40
Net cost to NB [Fixed] 12.40%
Net Cost to NB half yearly = 6.20%

Solution-6
Existing Loan of Sleepless = Floating rate payable = PLR+0.8%
Floating interest rate is expected to increase in future, hence Sleepless want to convert Existing loan from floating rate to
Fixed rate.
Swap Quotation by Bank
Floating Vs Fixed
=PLR+0.8% vs. 10%

Under swap, Sleepless shall get floating rate at PLR+0.8% and shall pay fixed rate 10%
Under swap, Bank shall pay floating rate at PLR+0.8% and shall get fixed rate 10%
Statement showing interest cost under the new arrangement [Existing Loan + Swap Agreement]
Net cost to Sleepless [Annually]
a) Payment to for actual loan [Floating] PLR + 0.8%
b) Receipt from Bank (Under swap) [Floating] PLR + 0.8%
c) Payment to Bank (Under-annual) [Fixed] 10%
d) Commission Payable to bank 0.2%
Net cost to Sleepless [Fixed] 10.20%

Analysis of IRS from Banks Point of View

Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.5
Scenario 1
Yr PLR Payable by Bank under Receivable Net Princip Net Amt PVF PV
IRS = PLR+0.8 by Bank Payable/(Rece al Amt Payable/(Receivable)
under IRS ivable)% Cr
1 10.25 10.25+0.8 = 11.05 10.20 0.85 50 50*0.85/100 = 0.425 0.909 0.38633
2 10.50 10.50+0.8 = 11.30 10.20 1.10 50 50*1.10/100 = 0.55 0.826 0.4543
3 10.75 10.75+0.8 = 11.55 10.20 1.35 50 50*1.35/100 = 0.675 0.751 0.50693
4 11.00 11.00+0.8 = 11.80 10.20 1.60 50 50*1.60/100 = 0.80 0.683 0.5464
1.89395

NPV is negative hence from bank’s point of view IRS is not viable

Solution-7
(a)
ABC is seeking fixed rate funding, but floating rate funding is available to ABC Bank at LIBOR+0.25% p.a. for 5 years.
IRSA of 5 years
Fixed rate vs Floating Rate = 7.5% vs Libor six months
Principal Amt = Rs.200 m
Period = 5yrs
For fulfilling his fixed rate funding ABC will do following steps
(i) ABC will raise loan of Rs.200 m for 5 yrs at floating rate of L + 0.25%
(ii) ABC will enter into IRSA for Rs.200 m for 5 years in which ABC will pay Fixed rate @ 7.5% and will receive floating
rate @ Libor
Net Cost to ABC under two agreements
Actual payment of Interest under floating rate funding L + 0.25
Settlement of IRSA
Interest receivable at floating rate under IRSA -L
Interest payable at fixed rate under IRSA 7.5%
Net Interest to ABC [Fixed Rate] 7.75%
Amt of Funding Rs.200m
Hence Net Cost of 200 m p.a. = 200m*7.75%*6/12 Rs.7.75m

(b)
ABC is seeking fixed rate funding, but floating rate funding is available to ABC Bank at LIBOR+0.25% p.a. for 5 years.

For this purpose three products are available which are as follows
(i) Hybrid instrument in which fixed rate @ 7.5% for first 3 years and floating rate @ L+0.25% for next two years
(ii) IRSA of 3 years
Fixed rate vs Floating Rate = 8% vs Libor
Principal Amt = Rs.200 m
Period = 3yrs

(iii) IRSA of 5 years

Fixed rate vs Floating Rate = 7.5% vs Libor
Principal Amt = Rs.200 m
Period = 5yrs

For fulfilling his fixed rate funding ABC will do following steps
(i) ABC issue hybrid instrument in which ABC pays fixed rate @ 7.5% for first 3 years and at floating rate @ L+0.25% for
next two years
(ii) ABC will enter into IRSA of 3 years for Rs.200 m in which ABC will receive Fixed rate @ 8% and will pay floating rate
@ Libor
(iii) ABC will enter into IRSA of 5 years for Rs.200 m in which ABC will pay Fixed rate @ 7.5% and will receive floating
rate @ Libor

Net Interest rate to bank

Particulars Year 1-3 Year 4-5
Interest payable under Hybrid Instrument 7.5% Libor + 0.25%
Settlement under 3 years Swap
- ABC will receive fixed rate -8% NA
- ABC will pay floating rate Libor NA
Settlement under 5 years Swap
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.6
- ABC will pay fixed rate 7.5% 7.5%
- ABC will receive floating rate -Libor -Libor
Net Interest Payable [Fixed Rate] 7% 7.75%

Selection of option between (a) and (b)

Net Cost to ABC under Year 1-3 Year 4-5
(a) 7.75% 7.75%
(b) 7% 7.75%

Option (b) is better than (a)

Solution-8
Principal Amt of Swap = Rs.500000
Interest Rate under Swap
Floating Vs Fixed
=Libor rate vs. 8%

(a)
Fixed rate p.a. = 8%
Interest for semi annual under Fixed rate obligation = Rs.500000*8%*180/360 = Rs.20000

(b) Floating rate payment

Libor rate p.a. = 6%
No of days for settlement = 181 days
Interest for semi annual under floating rate obligation = Rs.500000*6%*181/360 = Rs.15083.33

(c) Settlement under Swap Agreement = Interest under Fixed rate – Interest under Floating rate
= Rs.20000 – Rs.15083.33 = Rs.4916.67

Solution-8A
Principal Amt of Swap = Rs.600000
Interest Rate under Swap
Floating Vs Fixed
=Libor rate vs. 8%
(a)
Fixed rate p.a. = 8%
Interest for semi annual under Fixed rate obligation = Rs.600000*8%*180/360 = Rs.24000

(b) Floating rate payment

Libor rate p.a. = 6%
No of days for settlement = 181 days
Interest for semi annual under floating rate obligation = Rs.600000*6%*181/360 = Rs.18100

(c) Settlement under Swap Agreement = Interest under Fixed rate – Interest under Floating rate
= Rs.24000 – Rs.18100 = Rs.5900

Solution-9
Principal Amt of Swap = Rs.100000000
Interest Rate under Swap
Floating Vs Fixed
=Mibor rate vs. ?%
The swap was entered into on Monday, 2nd August, 2010 and was to commence on 3rd August, 2010 and run for a period
of 7 days.

Date Day Principal Mibor Interest Amt

03/02/2010 Tuesday 100000000 7.75 21,233
04/02/2010 Wednesday 100000000 8.15 22,329
05/02/2010 Thursday 100000000 8.12 22,247
06/02/2010 Friday 100000000 7.85 21,507
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.7
07/02/2010 & 08/02/2010 Saturday & Sunday(*) 100000000 7.98 43,726
09/02/2010 Monday 100000000 8.15 22,329
153,371
Derivative Bank will receive floating rate and will pay fixed rate
Interest obligation under floating rate obligation = Rs.153371
Net Receipts on Settlement by Derivative Bank = Rs.317
Interest obligation under Fixed rate obligation = Rs.153371 – 317 = Rs.153054
Fixed Interest rate for 7 days = Interest amt/Principal Amt = 153054/10,00,00,000 = 0.153%
Fixed Interest rate p.a. = 0.153%*365/7 = 7.977%
Note: Alternatively, answer can be calculated on the basis of 360 days in a year.

Solution-10
Buying caps means if market interest rate increase beyond 8%, then Mr X will exercise cap option.
If interest rate decrease below 8%, then Mr X will not exercise cap option.
Borrowing rate of loan for Mr X = Mibor + 0.50%
Interest rate [Mibor] 12% 9% 8% 7% 6%
Cap Rate 8% 8% 8% 8% 8%
Whether Mr X will exercise Cap Option [Lower] Yes Yes No No No
Gain to Mr X on Settlement of Cap Option [Speculative Transaction] 4% 1% 0 0 0
Interest Payable on actual Borrowing [Mibor + 0.50] 12.5% 9.5% 8.5% 7.5% 6.5%
Net Interest Rate of loan to Mr X = [Interest payable on actual loan – Gain] 8.5% 8.5% 8.5% 7.5% 6.5%
Hedging
By buying cap, Mr X has fixed upper limit of Interest rate at 8.5%, but lower limit of interest is open.

Solution-11
Actual Borrowing Rate = L + 0.6%
Cap Rate = 6.5%
Premium payable on Cap = 1.15%
Libor rate on Maturity 4.70% 5.80% 7.30%
Cap Rate 6.50% 6.50% 6.50%
Exercise of Cap option by holder [Lower] No No Yes
Gain to buyer of Cap on Settlement 0 0 0.80%
Interest payable on actual borrowing Rate of Loan [Libor + 0.60] 5.30% 6.40% 7.90%
Premium Paid on Cap 1.15% 1.15% 1.15%
Net Interest Rate of loan to Company [Interest payable on Loan – Gain + Premium paid] 6.45% 7.55% 8.25%
Maximum Cost of Borrowing to Company due to Cap = 8.25%

Solution-12
Cap rate = 8%
Principal Amount = Rs.100 Cr
Frequency of Settlement = Reset Period = Quarterly =
Quarter Q1 Q2 Q3 Q4
Libor rate at each quarter (Reset Period) 8.7% 8% 7.8% 8.2%
Cap Rate 8% 8% 8% 8%
Exercise of Cap option by holder [Lower] Yes No No Yes
Gain to buyer of Cap on Settlement 0.7% 0 0 0.2%
Gain in terms of interest = Rs.100 Cr*Gain%*3/12 0.175 Cr 0 0 0.05 Cr
Note: 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.

Solution-13
Borrowing Rate for £15 m at floating rate = Six Month Libor + 1% p.a.
Period = 24 months
Cap Rate = 8% p.a.
Premium = 1% for the entire reset period
Fixed Interest Rate = 7% [It is used for calculating PV of Premium Payable]
Premium payable for entire period = £15 m*1% = £0.15 m
Premium Payable for entire reset period = Premium payable for each reset period*PVAF(3.5%, 4 period)
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.8
£150000 = Premium payable for each reset period*3.673
Premium payable for each reset period = £150000/3.673 = £40861
Please note that above solution has been worked out on the basis of four decimal points at each stage.
Now we see the net payments received from bank
Half Year H1 H2 H3
Libor rate at each half 9% 9.5% 10%
Cap Rate 8% 8% 8%
Exercise of Cap option by holder [Lower] Yes Yes Yes
Gain to buyer of Cap on Settlement p.a. 1% 1.5% 2%
Gain in terms of interest = £15m*Interest Rate*6/12 = 15m*0.01*6/12 15m*0.015*6/12 15m*0.02*6/12
£75000 £112500 £150000
Less: Premium Paid £40861 £40861 £40861
Net Gain of Interest on Cap £34139 £71639 £109139

Thus from above it can be seen that interest rate risk amt of £337500 reduced by £214917 by using of Cap Option

Solution-14
Buying floor means if interest rate increase beyond 7%, then Mr X will lapse floor option
If interest rate decrease beyond 7%, then Mr X will exercise floor option.
Deposit rate for Mr X = Mibor + 0.70%
Interest rate 12% 9% 7% 6% 5%
Floor Rate 7% 7% 7% 7% 7%
Whether Mr X will exercise Floor Option No No No Yes Yes
Gain to Mr X 0 0 0 1% 2%
Actual deposit Rate [Mibor + 0.75] 12.75% 9.75% 7.75% 6.75% 5.75%
Net interest rate receivable by Mr X 12.75% 9.75% 7.75% 7.75% 7.75%
By buying floor, Mr X has fixed lower limit of Interest rate, but upper limit of interest is open.

Solution-15
There is a payoff to the floor if 3-month MIBOR is less than the floor rate. For Periods 1 and 2, there is no payoff because
3-month MIBOR is greater than the floor rate. For Periods 3 and 4, there is a payoff and the payoff is determined by:
Rs.200 crore x (Floor Rate - 3-month MIBOR)/4
The payoffs are summarized below:
Quarters 3-months MIBOR Strike Rate of Exercise by Gain Principal Amt Pay-off (Rs.)
(%) Floor Holder
1 4.70 4% No 0 200 Cr -
2 4.40 4% No 0 200 Cr -
3 3.80 4% Yes 0.20% 200 Cr 200*0.20%/4 = 0.1 Cr
4 3.40 4% Yes 0.60% 200 Cr 200*0.60%/4 = 0.3 Cr

Solution-16
Period Libor Cap Exercise Gain Floor Exercise Gain Net Principal No of Net Gain/(Loss) in intt
Rate Rate gain/(Loss) to Amt days
Collar Buyer
31- 6.00 7% No 0 4% No 0 0 10m 184 0
12-13
30- 7.50 7% Yes 0.50% 4% No 0 0.50% 10m 181 10*0.50%*181/365
06-14 =0.024795 m
31- 5.00 7% No 0 4% No 0 0 10m 184 0
12-14
30- 4.75 7% No 0 4% No 0 0 10m 181 0
06-15
31- 3.75 7% No 0 4% Yes 0.25% -0.25% 10m 184 10*0.25%*184/365 =
12-15 - 0.012603 m
30- 4.25 7% No 0 4% No 0 0 10m 181 0
06-16

Calculation of Effective Interest

Period Libor Principal No of Net Gain/(Loss) in Intt rate on Intt Amt Effective
Amt days intt Actual Loan = Intt
L+0.5%
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.9
31-12-13 6.00 10m 184 0 6.50% 10*6.50%*184/365 = 0.327671 0.327671
30-06-14 7.50 10m 181 0.024795 m 8.00% 10*8.00%*181/365 = 0.396712 0.371917
31-12-14 5.00 10m 184 0 5.50% 10*5.50%*184/365 = 0.277260 0.277260
30-06-15 4.75 10m 181 0 5.25% 10*5.25%*181/365 = 0.260342 0.260342
31-12-15 3.75 10m 184 - 0.012603 m 4.25% 10*4.25%*184/365 = 0.214247 0.22685
30-06-16 4.25 10m 181 0 4.75% 10*4.75%*184/365 = 0.239452 0.239452

Solution-17
Today date is 01/04/2007
A Ltd wants to Invest Rs.1000000 for a period of 6 months after 3 months from today.
A Ltd has fear that interest rate may come down after 3 months, for hedging A Ltd can enter into FRA with Bank as
follows:
Date of FRA Agreement = 01/04/2007
It will be effective for a period = 01/07/2007 to 31/12/2007
The bank quotes the FRA rate 10% p.a. v/s MIBBOR +1%.
This is known as a ‘3×9’ FRA.
Under the agreement the bank will pay them interest at 10% p.a. on Rs.10,00,000 for six months and A Ltd. will pay the
bank interest at the floating interest prevailing on 29th June 2007 (i.e. 2 days before the date of actual investment) for
six months deposit.
The transactions will be settled on net basis through a single payment of present value of interest differential on
Rs.10,00,000; the present value being calculated using reference rate as discount rate

29th June,2007 Date on which the underlying rate is determination date.

st
1 July,2007 Date of termination of FRA, it is also known as termination date.
1st July,2007 to 31st December,2007 Period for which interest differential is to be paid or received.

Suppose on 29th June 2007, the MIBOR for six months deposit is 8% p.a. The reference rate is 9% p.a.
Mibor Rate 8% 9% 11%
Reference rate (Mibor+1) 9% 10% 12%
Under FRA
A will receive from Bank 10% 10% 10%
A will pay to Bank 9% 10% 12%
(a) Speculative Transaction
Gain/(Loss) on settlement of FRA at termination 1% 0% -2%
date (%)
Gain/(Loss) on settlement of FRA (Amt) 1000000*1%/2 1000000*1% 1000000*2%/2
This is payable on 31/12/2007 5000 0 -10000
But settlement is done at termination date i.e. on 5000/1.045 -10000/1.06
01/07/2007
Net Gain/(Loss) at termination date Rs.4785 - Rs.9434
(b) Hedging
A will deposit Rs. 1000000+4785 = 1000000 1000000-9434 =
1004785 990566
Interest rate (Mibor + 1) 9% 10% 12%
Amt receivable after 6 months 1004785*1.045 1000000*1.05 990566*1.06
1050000 1050000 1050000
Hence, A Ltd. has been able to earn a return of 10% p.a. (the return it expected on 1st April; through the investment was
made on 1st July)

Solution-18
Today date is 01/04/2007
A Ltd wants to borrow Rs.1000000 for a period of 1 yr months after 3 months from today.
A Ltd has fear that interest rate may increase after 3 months, for hedging, A Ltd can enter into FRA with Bank as follows:
Date of FRA Agreement = 01/04/2007
It will be effective for a period = 01/07/2007 to 30/06/2008
The bank quotes the FRA rate 10% p.a. v/s Borrowing rate on the reference date
This is known as a ‘3×15’ FRA.
Under the agreement A Ltd. will pay interest at fixed interest of 10% and bank will pay interest at interest rate prevailing
for borrowing on 29th June 2007.
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.10
Suppose on 29th June 2007, the borrowing rate is 11% p.a.
Under the FRA, on 1st July, 2007 the bank will pay interest at the rate of 11% pa. on Rs.10,00,000 to A Ltd. and A Ltd.
will pay interest at the rate of 10% p.a. to the bank.
The net payment made at the termination date
A Ltd will pay = Rs.1000000*10% = Rs.100000
A Ltd will receive = Rs.1000000*11% = Rs.110000
Net payment on Settlement = Rs.100000 – Rs.110000 = Rs.10000 payable on 30/06/2008
Net payment on termination date = Rs.10000/(1+0.11) = Rs.9009 [Payable by Bank to A]

Now A Ltd. is able to borrow Rs.10,00,000 - 9009 on 1st July,2007 at 11%.

The amount to be payable by A Ltd. on maturity = (1000000 -9009)*(1.11) = 1100000
Cost to A Ltd = Rs.100000/1000000 = 10%

Solution-18A
Today date is 01/04/2007
A Ltd wants to invest Rs.1000000 for a period of 1 yr months after 3 months from today.
At present interest rate = 9.75%
Date of FRA Agreement = 01/04/2007
It will be effective for a period = 01/07/2007 to 30/06/2008
The bank quotes the FRA rate 9.5% p.a. v/s Deposit rate on reference date.
This is known as a ‘3×15’ FRA.
Under the agreement A Ltd. will receive interest at fixed interest of 9.5% and bank will receive interest at prevailing rate
for deposit on 29th June 2007.

On 29th June 2007, the Deposit rate is 9% p.a.

Under the FRA, on 1st July, 2007 the bank will receive interest at the rate of 9% pa. on Rs.10,00,000 from A Ltd. and A
Ltd. will receive interest at the rate of 9.5% p.a. from the bank.
The net payment made at the termination date
A Ltd will receive = Rs.1000000*9.5% = Rs.95000
A Ltd will pay = Rs.1000000*9% = Rs.90000
Net payment on Settlement = Rs.95000 – Rs.90000 = Rs.5000 payable by Bank to A on 30/06/2008
Net payment on termination date = Rs.5000/(1+0.09) = Rs.4587 [Payable by Bank to A]

Now A Ltd. will deposit Rs.10,00,000 + 4587 on 1st July,2007 at 9% in Market

The amount receivable by A Ltd. on maturity = (1000000+4587)*(1.09) = 1095000
Return to A Ltd = Rs.95000/1000000 = 9.5%

Solution-18B
Company wants to invest Euro 1m for a period of 3 months after 24 months from today.
The bank quotes the FRA rate 5% p.a. v/s Deposit rate on reference date.
This is known as a ‘24×27’ FRA.
Under the agreement Company will receive interest at fixed interest of 5% and bank will receive interest at prevailing rate
for deposit on reference date.

On reference date, the Deposit rate is 5.50% p.a.

Under the FRA, at termination date, the bank will receive interest at the rate of 5.50% p.a. on Euro 1m and Company will
receive interest at the rate of 5% p.a.
The net payment made at the termination date
Company will receive = Euro 1m*5%*3/12 = Euro 0.0125m
Company will pay = Euro 1m*5.5%*3/12 = Euro 0.01375m
Net payment on Settlement = 0.01375 – 0.0125 = Euro 0.00125 m payable by Company to bank after 27 months from
today
Net payment on termination date = Euro 0.00125/(1+0.01375) = Euro 0.001233m [Payable by Company to bank]

(a) Now Company will deposit Euro1m – 0.001233m = Euro 0.998767 m after 24 months
(b) The amount receivable by Company on maturity = (0.998767)*(1.01375) = Euro 1.0125m
Return to Company = 0.0125/1 = 1.25% for 3 months
Return to Company = 1.25%*4 = 5% p.a.

Solution-19
Interest rate on reference date 9.60% 8.80%
Reference rate 9.60% 8.80%
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.11
Under FRA
Mr Parker will pay to Bank – Fixed (Under FRA) 9.30% 9.30%
parker will receive from Bank – Reference rate 9.60% 8.80%
(a) Speculative Transaction
Gain/(Loss) on settlement of FRA at termination 0.30% (0.50%)
date (%)
Notional Amount 60 Cr 60 Cr
Gain/(Loss) on settlement of FRA (Amt) 600000000*0.30%*3/12 = 600000000*0.50%*3/12 =
450000 (750000)
Discount Rate = Reference Rate 9.60% 8.80%
Discount rate for 3 months 9.60/4 = 2.40% 8.80/4 = 2.20%
But settlement is done at termination date 450000/1.0245 = 439238 750000/1.022 = 733855
Receivable by Parker Payable by Parker

Alternative Method as per suggested

N (RR-FR)(dtm/360/1+RR (dm/360)
Where
N =National Principal Amount
RR =Reference Rate
FR =Agreed upon Forward Rate
Dtm=FRA period specified in days.
Accordingly:
If actual interest rate after 6 months happens to be 9.60%
600000000 (0.096-0.093)(3/12)/1+0.096(3/12) =Rs.439453 receiable by parker

If actual interest rate after 6 months happens to be 8.80%

600000000 (0.088-0.093)(3/12)/1+0.088(3/12) =Rs.733855 payable by parker

Solution-19A
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:

N (RR-FR)(dtm/360/1+RR (dm/360)
Where
N =National Principal Amount
RR =Reference Rate
FR =Agreed upon Forward Rate
Dtm=FRA period specified in days.
Accordingly:
100 (5.50%-5.25%)(92/360)/1+0.055 (92/360) =Rs.6,30,032

Solution-20
(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 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:
Particulars If the rate turns out to be 4.50% If the rate turns put 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) €50m×1.44×1/2=€360,000 €50m×0.56%×1/2=(€140,000)
Interest after 6 months on =€50m×4.5%×1/2 =€1,125,000 =€50m×6.5%×1/2 =€1,625,000
€50m Million at actual rates
Net Out Flow €1,1485,000 €1,485,000
Thus entering into FRA, the firm has committed itself to a rate of 5.94% as follows:
€1,485,000 × 100×12/16 = 5.94%
€50,000,000

(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.
Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.12
No. of contracts = (Amount of Borrowing*Duration of Loan)/(Contract Size93 months)
= (50,000,000*6)/50000*3 = 2000 contract
The final outcome in the given two scenarios shall be as follows:
If the interest rate turns out to be 4.5% If the interest rate turns out to be 6.5%
Future Course Action 94.15 94.15
Buy to close 95.50(100-4.5) 9.3.50(100-6.5)
Loss(Gain) 1.35% (0.65%)

Future Cash Settlement

Future Cash Payment (Receipt) €50,000*2000*1.35%*3/12 = €50,000*2000*0.65%*3/12 =
€337,500 (€162,500)
Interest for 6 months on €50 million at 50 million×4.5%×1/2 = €11,25,000 €50 million×6.5%×1/2 = €16,25,000
actual rates
€1,462,500 €1,462,500

Thus, the firm locked itself in interest rate €1,462,500 × 100×12/6=5.85%

€50,000,000

Solution-21
(a) 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+IR1-3)(1+FR4-6) = (1+IR1-6)
(1+0.05*6/12) = (1+0.045*3/12)*(1+FR4-6)
(1.025) = (1.01125)*(1+FR4-6)
FR4-6 = 1.025/1.01125 – 1 = 0.01359 = 1.359%
FR4-6 = 1.359*4 = 5.44% p.a.

(b) 6 months interest rate is 5% p.a & 12 month interest rate is 6.5% p.a.
Calculation of TFV FR7-12
(1+IR1-6)(1+FR7-12) = (1+IR1-12)
(1+0.05*6/12)* (1+FR7-12) = (1+0.065)
FR7-12 = 1.065/1.025 – 1 = 0.039 = 3.90%
FR7-12 = 3.90*2 = 7.8% p.a.

The bank is quoting 6/12 USD FRA at 6.50 -6.75%

Threfore there is an arbitrage opportunity of earning interest @ 7.80% p.a. & Paying 6.75%

Arbitrage Profit
Today
(1) Borrow Rs.10000 for 6 months @ 5%
(2) Buy an FRA 6 v 12 @ 6.75% for Nominal Amount Rs.10000
(3) Invest Rs.10000 for 12 months @ 6.50%

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+0.675/2)=(1.05959) say 1.060

Solution-22
Yield Curve means
(i) DEF Bank fix interest rate for 2V3 FRA after 2 years as follows:
Calculation of forward rate for third Year
(1+YTM2 year)2(1+FR3) = (1+YTM)3
For XYZ Ltd.
(1+0.0420)2(1+FR3) = (1+0.0448)3
(1+FR3) (1.0420)2 = (1.0448)3
FR3 = 1.140511/1.085765 - 1 = 5.04%

Bank will quote 5.04% for a 2V3 FRA to XYZ Ltd

Chap – 11D IRS, CAPS, FLOOR, FRA - SOLUTION 11DC.13

For ABC Ltd.

(1+0.0548)2(1+FR3) = (1+0.0578)3
(1+FR3)(1.0548)2 = (1.0578)3
FR3 = 1.183616/1.112603 - 1 = 6.38%

Bank will quote 6.38% for a 2V3 FRA to ABC

(ii) Bank offers interest Rate Guarantee for a premium of 0.1% of the amount of loan you required to calculate the
interest payable by XYZ Ltd. if interest in 2 years turns out to be
Particulars 4.50% 5.50%
Interest rate quoted by Bank under Option for borrowing 5.04% 5.04%
XYX will borrow from Market From Bank
Exercise of Option by XYZ No Yes
Interest rate applicable 4.50% 5.04%
Interest amt 100*4.50% = 450 Cr 100*5.04% = 504Cr
Add: Premium Paid 100*0.1% = 10 Cr 100*0.1% = 10 Cr
Total Cost 460 Cr 514 Cr