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Dear Sir,
Why in hedging with interest rate FRA, the FRA has created a liability instead of ‘locking’ the interest income rate with which the company will invest its money in the bank?
FRA’s do ‘lock-in’ a rate.
However the way they work is that you pay whatever the actual interest rate is at the start of the loan, and then you settle up with the FRA department the difference between the actual rate and the FRA agreed rate.
I am pretty sure that I mention this in my P4 lectures – I certainly do in the F9 lectures (this is a topic from F9).
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Thank you very much for the reply.
To provide some insight to tutors as to what goes inside a student’s head, like myself, and got the above confused are the following:
1. In currency FRA, the FRA ‘locks in’ the currency that a company will pay/receive. No need to convert the currency using spot rate at the conversion date and then calculate gain/loss from FRA. (Kenduri 6/2013). This is not the case with Awan Co (Dec 2013). Correct ?
2. I often get confused in that we must get a gain from using derivatives. No. Derivatives’ purpose is to get a gain/loss so as to smooth the cash flows. Smoother cash flows = lower risk of default and business risk, hence lower equity beta (and cost of equity) and lower risk of cost of debt (due to lower risk of default). Correct?
3. In Phobos (Dec 2008) the answer does not prorate the gain & premium from using options. But Awan does prorate gain & premium by 3/12. When should we time apportion the gain & premium from options?
1.We only use the abbreviation FRA in relation to fixing interest rates.
Forward rates for currency transactions do fix the exchange rate – the conversion takes place at that agreed rate.2. It depends which derivatives you are referring to. What you are writing about are futures and what you say is correct. (For options you are not correct – options will only be exercised if there is a gain).
3. Interest rate futures are always 3 months futures and the gain when using options on futures is always 3/12. Similarly the premium on options is calculated as 3/12. This has been done in Phobos as well – it is just that they have used ticks (which you never actually need to in the exam – it is your choice) and the value of a 1 tick movement is 0.01% x 500,000 x 3/12 = 12.50. I do explain ticks in my free lectures.
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