Reference no: EM133110315

A financial firm plans to borrow $100 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 sources suddenly rise to 5.5 percent as the borrowing begins, how much interest in total will the firm owe and how much of an interest rebate will it receive, assuming the borrowing is for only one month?

[HINT: An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. Similarly an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.