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Entity S enters a ₹100 cr notional 5-year pay-fixed (10%) / receive-MIBOR interest rate swap with Counterparty C, BUT pre-pays the entire fixed leg of ₹50 cr (= 100 × 10% × 5) at inception, then receives quarterly MIBOR-linked variable payments over the swap life. Is this contract a derivative?
AYes — initial net investment of ₹50 cr is significantly smaller than the ₹100 cr notional and is smaller than what a comparable instrument (e.g., variable-rate bond) would require
BNo — the ₹50 cr prepayment makes the contract a loan, not a derivative
CYes, but only because of the future settlement; the initial investment criterion is breached
DNo — the entity has prepaid its fixed obligation, so it has performance neither to deliver nor receive at maturity
Answer & Solution
Correct answer: A. Yes — initial net investment of ₹50 cr is significantly smaller than the ₹100 cr notional and is smaller than what a comparable instrument (e.g., variable-rate bond) would require
Even with the prepayment of ₹50 cr, the initial net investment is still significantly LESS than what would be required for a contract with similar response to market changes (e.g., a ₹100 cr variable-rate bond). The contract changes value with MIBOR and is settled over time. All three derivative criteria are met.
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