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Dear Sir,
I am confused when reading the solutions for these 2 questions:
Awan Co: Awan Co can invest funds at the relevant inter-bank rate less 20 basis points so in the solution we select 4.82% minus 0.2% to come to effective rate at 4.62%
FNDC: FNDC can borrow at LIBOR plus 1.25%. In the solution under the forward rate agreements they use the FRA 5-7 to give the rate of 5.85%. Why dont we add 1.25% to 5.85%? where as in Awan question, we minus 20 points.Thanks,
DTThe quotes given for FRA’s are specific to the particular company and will already include any risk premium.
Dear John, i am still not clear. If the quote already include risk premium, why do we still minus 0.2% in Awan question? Thanks
But we don’t deduct it from the FRA.
The settling of the FRA is the difference between LIBOR and the FRA.
It is the return on the investment that is reduced by 0.2%.(Which does give an effective net rate of 4.62%)
Dear Sir,
But if so, the effective net rate in FNDC question should also be added 1.25% because the bank pays us/ we pay the bank the differences between FRA & LIBOR?
Effective rate (Awan) = LIBOR – 0.2 +/- (LIBOR – FRA)
Effective rate (FNDC) = LIBOR + 1.25 +/- (LIBOR – FRA)You are right in that the answers are inconsistent – it is because the questions were set by different examiners.
Awan is the one to learn from, because it was set by the current examiner 🙂
(He took over at the end of 2010)
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