Question

FRA single payment loan

On 15 April, Company A determines that it will borrow $50 million on 20 August. The loan will be repaid 180 days later on 16 February, and the rate will be at LIBOR plus 200 basis points. Because Company A believes that interest rates will increase, it decides to manage this risk by going long an FRA. An FRA will enable it to receive the difference between LIBOR on 20 August and the FRA rate quoted by the dealer on 15 April. The quoted rate from the dealer is 3.00 percent. Company A wants to lock in a 5.00 percent rate: 3.00 percent plus 200 basis points.

Company A confirms that it will borrow $50 million at LIBOR plus 200 basis points on 20 August. Company A goes long an FRA at a rate of 3.00 percent to expire on 20 August with the underlying being 180-day LIBOR. At contract expiration, 180-day LIBOR is 4.00 percent. Show how FRA is helpful in managing the interest rate risk.

how can I solve this?

Answer 1

The attached image exhibits how the proceeds from the FRA contract offset the effect of increased 180-day LIBOR rate, effectively capping the LIBOR rate at 3% and the interest rate at 5% and helping company A manage interest rate risk.

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