Homework 2 Forward Rate Agreement (Review on Monday, November 2)

1. Today is November 1st. An entrepreneur wants to borrow $10 million from a commercial
bank on May 1st next year to start a business. The borrowing period will be three months,
and she plans to pay off the loan on August 1, 2021. The current pandemic situation is
expected to improve and becomes normalize by the time she starts a business. She
expects the borrowing rate may go up to 8% by the time she borrows the money.
However, she does not want to borrow money now and pay the interest unnecessarily for
six months even if the current interest rate, which is 7%, is considered low. To hedge
against the interest rate risk, she looks into the FRA market. The FRA dealer offers the
following contract terms based on LIBOR as the base rate and the nominal amount of $10
million:

“6 x 9 at 4%”

A. What position does she need to take, long or short position?

B. What does it mean by “6 x 9 at 4%”?
C. Assume that she signed the FRA contract, and on May 1 st, she borrowed $10 million
for 90 days from a local bank at the interest rate of 8% per annum. By this time, the
LIBOR becomes 5%. Illustrate how she can hedge the interest rate risk using the FRA
contract, and explain the results when the FRA contract settled at the maturity date,
May 1st.

|___________________________________________|___________________________|
Nov. 1 May 1 Aug. 1
FRA signed FRA matured Borrowing
matures
6X9 at 4% Borrow at 8%
Expect to borrow at 7% FRA settled

(A)

(B)6*9 AT 4% means An FRA having a 6-month/180 days waiting period (forward) and a 3
month/90 days contract period at 4% annual interest rate.
(C)Total payment to the bank on August 1st
Implied forward rate=4% per annum

Implied forward rate for quarter=4%/4=1%

Borrow $10000000 at 8% but the LIBOR becomes 5% annualy

LIBOR RATE In quarter=5%/4=1.25

FRA Settled at =1.25% but the Implied forward rate was 1%

So,the borrower receives at august 1st:$10000000*(1.25%-1%)
=$25000

Expected amount of interest payment at 7%/year:

Expected amount of interest quarterly=7%/4=1.75%

Expected amount of interest=$10000000(1.75%-1%)=$75000

Actual payment of interest at 8%/year:

Actual Payment of interest at quarterly=8%/4=2%

Actual payment of interest=$10000000(2%-1%)=$100000

FRA settlement amount on May 1st:

Implied forward rate=4% per annum

Implied forward rate for quarter=4%/4=1%

Borrow $10000000 at 8% but the LIBOR becomes 5% annualy

LIBOR RATE In quarter=5%/4=1.25%

FRA Settled at =1.25% but the Implied forward rate agreement was 1%
At May 1st,
Borrower receives a discounted amount/settlement
amount=$10000000*(1.25%-1%)/(1+0.0125)

=$24691.35802