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Hi,
This question relates to Q4 of the Mock Examination Set 4.
KEW Co is planning an investment of $10 million for a six-month period starting in three months’ time. KEW Co is worried about interest rates falling and hedges the risk using an appropriate FRA as follows:
6-9 FRA 2.80%-3.10%
3-9 FRA 3.00%-3.20%Assume that in three month’s time, interest rates are 3.50%.
My answer was the bank had to pay the difference of $15,000 [$10m x (3.5-3.5)% x 6/12] to the company.
However, the answer shows that the correct answer is KEW pays the bank $25,000 [$10m x (3.5-3.0)% x 6/12].
Shouldn’t I take the higher % of the 3-9 FRA?
And since the actual rate was higher than the agreed rate, shouldn’t the bank pay the company for the difference?
The lower interest rate is the interest received on deposits, the higher interest rate is the interest charged on borrowings (the difference is so that the banks make a profit).
Because the company is depositing money, it is the lower interest rate that applies and because Kew has agreed a rate of 3.00% with the bank they have to pay the bank the extra 0.5%.
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