(1) Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency.

A four-year CHF60,000,000 loan taken out to part-fund the setting up of four branches.

Interest will be payable on the loan at a fixed annual rate of 2•2% or a floating annual rate based on the yield urve rate plus 0•40%.

The loan’s principal amount will be repayable in full at the end of the fourth year.

Required:

(c) As an alternative to paying the principal on the loan as one lump sum at the end of the fourth year, CMC Co could pay off the loan in equal annual amounts over the four years similar to an annuity. In this case, an annual interest rate of 2% would be payable, which is the same as the loan’s gross redemption yield (yield to maturity).

Required:

Calculate the modified duration of the loan if it is repaid in equal amounts and explain how duration can be used to measure the sensitivity of the loan to changes in interest rates. (7 marks)