AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E3. The use of financial derivatives to hedge against interest rate risk

E3a. Forward rate agreements (FRA) 5 / 13

Syllabus E3a)

a) Evaluate, for a given hedging requirement, which of the following is the most appropriate given the nature of the underlying position and the risk exposure:

i) Forward Rate Agreements (FRAs)

FRA quotations or prices

FRAs are over-the counter transaction between a bank and a company.

The bank quotes two-way prices for each FRA period for each borrowing (loan) or lending (deposit).

An example of bank quotations for FRA:

  • 3 v 6     5.25 - 7.00

    Means forward rate agreement that start in 3 months and last for 3 months at a borrowing rate of 7% and lending rate of 5.25%.

Example

A bank has quoted the following FRA rates:

Assume that now is 1st October 2013.

2 v 7 5.25 - 6.25
3 v 5  6.00 - 7.00
4 v 6 5.85 - 6.35

Required:

Determine the FRA interest applicable to the following situations:

1. A company wants to borrow on 1st February 2014 and repay the loan on 1st of April 2014.

2. A company wants to deposit money on 1st December 2013 and expect to withdraw the amount for an investment on 1st of May 2014.

3. A company wants to borrow on 1st January 2014 and repay the loan on 1st of March 2014

Solution

  1. 4 v 6 at a borrowing rate of 6.35%

  2. 2 v 7 at lending rate of 5.25%

  3. 3 v 5 at a borrowing rate of 7.00%