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When hedging interest rate risk by FRA, if we are told that we can borrow at LIBOR + 1%, and FRA is 5% which means that fixed interest rate of 5%. Does it mean we can borrow at a floating rate of 6% [which is made up of LIBOR + 1 where LIBOR is 5% + 1 = 6% of floating interest rate]. true?
LIBOR is actually a fixed interest rate that always comes with + 1 to make it a floating interest rate. Secondly, if there is an increase in the floating rate then what will increase LIBOR or +1 will part become +2 or +3???
LIBOR is the official rate than banks charge each other and is a floating rate – it keeps changing.
Companies that borrow at floating rate get charged more than LIBOR depending how risky the lenders think that the company is, which is why they might be charged LIBOR +1 or LIBOR + 2, etc..
If the company has arranged an FRA at 5% with a bank, then they will end of paying a fixed 5%. If the floating rate they are charged turns out to be more than 5% then the bank will pay them the difference. If the floating rate turns out to be less that 5% then the company has to pay the bank the difference. Either way the company ends up paying a net 5% whatever happens to LIBOR.
Have you watched my free lectures on interest rate risk management? The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Sir can you please explain me this question how to answer this one!
Lagrag Co is a heavily indebted company which is keen to protect the interest payments on
$10 million of borrowings which will be required in 3 months for a period of 4 months. The
company has discovered that the following forward rate agreements are currently available
to it:(3 v 4) 7.45 – 7.34
(3 v 7) 7.53 – 7.43
(4 v 7) 7.58 – 7.45Required:
(a) Identify the appropriate forward rate agreement and show what the cash flows
arising will be if the interest rate payable by Lagrag Co in 3 months is:(i) 7.76%
(ii) 7.42%Why are you attempting a question for which you do not have an answer? You should be using a Revision Kit from one of the ACCA Approved Publishers – they have answers and explanations
🙂Also, why have you not watched my free lectures on interest rate risk management where I explain FRA’s?
They will have agreed a 3 v 7 FRA on $10M with the bank, and will therefore be guaranteed an interest rate of 7.53% per year for 4 months
So if the actual rate is 7.76% p.a., they will be 4/12 x 7.76% x $10M to the lender, and will receive back from the FRA 4/12 x (7.76% – 7.53%) x $10M from the bank.
If the actual interest rate is 7.42%, then it is the same workings except that they will have to pay the difference in the interest rates to the bank.
Sir can you please explain how do you come to USE 7.53% but not 7.43% which is on the (3 v 7) interest rate given as (7.53% – 7.43%)
Is it correct that the higher interest rate of 7.53% is applied on the BORROWING
And lower interest rate of 7.43% is applied on the DEPOSITINGAs u said in your lecture please correct me if I get it right that FRA is where we locked the interest rate but the actual interest rate fluctuates from day-to-day which means that we have to pay interest on borrowing upon actual interest rate BUT the bank will return the overpaid interest payment or they can ask for in case of unpaid interest payment since we have Locked-in the FRA rate. [correct?]
Last of all, I have seen few FRA questions overall & mostly of them are Borrowing cases not Depositing cases. Can you please tell me any question where I can see the Depositing case? I have an examkit but they don’t have that in there!
It is always that the higher rate is the interest charged on borrowings and the lower rate in the interest rate given on deposits.
Your second paragraph is correct, and is what I wrote in my first reply 🙂
I cannot remember any questions involving depositing, but the logic is exactly the same 🙂
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