# Effective interest rates and hedge

Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust.

The small chemical company's amount to be borrowed is: $500,000

The bank offers a rate of 9 percent with a 20 percent compensating balance

requirement, or as an alternative, 11.5 percent with additional fees of $5,575

to cover services the bank is providing. In either case the rate on the loan is

floating (changes as the prime interest rate changes), and the loan would be

for one year.

a. Calculate the effective rate for both loan scenarios. Consider fees to be the

equivalent of "other interest" for Scenario 2.

b. If the loan with the 20% compensating balance were to be paid off

in 12 monthly payments, what would the effective rate be?

(Principal equals amount borrowed minus compensating balance.)

c. Because the interest rate on the loans is floating, it can go up as

interest rates go up. Assume that the prime rate goes up by 2%

and the quoted rate on the loan goes up by the same amount.

What would then be the effective rate on the loan with

compensating balances? Convert the interest rate to dollars

as the first step in your calculation.

d. Assume the proceeds from the loan with the compensating balance

requirement will be used to take cash discounts.

If the terms of the cash discount are 2/10, net 60, should the firm

borrow the funds to take the discount?

Use the loan cost from part A as the basis and validate by showing your answer in

percentage amounts.

e. In order to hedge against the possible rate increase, Midland Chemical Co.

decides to hedge its position in the futures market. Assume it sells $500,000

worth of 12-month futures contracts on Treasury bonds. One year later, interest

rates go up 2.5 percent across the board and the Treasury bond futures have gone

down to $479,000. Has the firm effectively hedged the 2.5 percent increase in

interest rates on the bank loan of $650,000? Determine the answer in dollar amounts.

https://brainmass.com/business/interest-rates/effective-interest-rates-and-hedge-338518

#### Solution Summary

The solution explains how to calculate the effective interest rate and hedging against increase in interest rates