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Question 8.P.16: A financial firm plans to borrow $75 million in the money ma...

A financial firm plans to borrow $75 million in the money market at a current interest rate of 4.5 percent. However, the borrowing rate will float with market conditions. To protect itself the firm has purchased an interest-rate cap of 5 percent to cover this borrowing. If money market interest rates on these funds suddenly climb to 5.5 percent as the borrowing begins, how much in total interest will the firm owe and how much of an interest rebate will it receive assuming the borrowing is only for one month?

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Total Interest Owed = Amount Borrowed * Interest Rate Charged * \frac{\text { Number of Months }}{12}

 

=\$ 75 \text { million } \times 0.055 \times \frac{1}{12}

 

= $0.34375 million or $343,750.

 

How much of an interest rebate will the bank receive for its one-month borrowing?

 

Interest Rebate = Market Interest Rate – Cap Rate × Amt. Borrowed × \frac{\text { Number of Months }}{12}

 

=(.055-.05) \times \$ 75 \text { million } \times \frac{1}{12}

 

= $31,250.

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