A company is considering hedging the interest rate risk on a 3-year floating rate borrowing...

Effective borrowing costs:

No hedge (D): pay floating = 2%, 3%, 4%

Average = (2 + 3 + 4) / 3 = 3.0%

Swap at 3.1% (A): fixed 3.1% every year

Average = 3.1%

Cap at 3% with premium 0.533% (B):

Year 1: 2% + 0.533 = 2.533%

Year 2: 3% + 0.533 = 3.533%

Year 3: min(4%,3%) + 0.533 = 3.533%

Average ≈ 3.20%

Zero-cost collar 2.9–4% (C):

Year 1: floored at 2.9%

Year 2: 3%

Year 3: 4% (at cap)

Average = (2.9 + 3 + 4) / 3 ≈ 3.30%

Lowest cost is no hedge.

Answer Q74: D