Question

You have given a floating rate loan of rupees 10 crores to your borrower currently carrying an interest rate of 8% p.a.

Interest rates are feared to decline and therefore you have entered into a contract with a hedge fund whereby you have been sold and interest rate floor of 8% p.a. to hedge your risk against the declining interest rates in consideration of an upfront premium of rupees 10 lakhs by you.

Subsequent to your hedging contract, the interest rates rise by 2% to 10% p.a.

Which party will pay how much and to whom?

Answer 1

In this case, since the hedge fund has sold a floor, the hedge fund will pay only when the Interest rate goes below 8% and the hedge fund will pay the difference.

Now, as the Interest rates have risen , We have to pay the hedge fund an amount of Rs.10 lakhs as upfront premium.

Subsequent to the contract, there is no payment to be exchanged between us and hedge fund

Our borrower will continue to pay interest on floating rate at 10%

So, in this case, under the floor contract, subsequent to the contract , there will be no payments