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Sir, there is a question called Lagrag Co in BPP Kit.
[Question]
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 – 7.45Identify 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%[My Answer]
Since we have locked the FRA to (3v7) which I completely understood (thanks to your lecture :)) but the current interest rate is 7.76% and we will pay interest on this rate.However, the bank will return the extra interest that we paid on 7.76% because we had locked the FRA rate at 7.53%. [Is it correct?] So, the difference between 7.76% & 7.53% will be compensation received (I don’t know the correct term so I used compensation received – I hope it is correct & if not please do correct me)
Secondly, can you please explain me how do I choose the correct interest rate of FRA since we’ve been given two interest rate 7.53 – 7.43. And I can’t decide how do we get the correct interest rate.
[I guess the higher interest rate of 7.53% is for borrowing & lesser interest rate of 7.43 is for depositing]
Everything that you have typed is correct.
And yes, the higher rate is always the rate for borrowing money and the lower rate is always the rate when depositing money.
Thanks for your reply!
Could you please correct me here if we take Lagrag Co (example) as a depositing case (rather than borrowing!). Let’s say that company has deposited $10m in the bank for 4 months on FRA.
I doing this because I couldn’t find any question of interest risk rate on depositing. Hope you wouldn’t mind helping me on this one too 🙂
[My Answer]
Since we have locked the FRA to (3v7) but the current interest rate on deposit is 7.76% and we will receive interest on this rate.[Calculations]:
Since the actual rate of interest is 7.76% so that we will receive interest based on this rate such as:Interest received on actual interest rate : $10m x 7.76% = $0.776m
However, the company will return the extra interest that we receive on 7.76% because we had locked the FRA rate at 7.43%. [Therefore, the difference between 7.76% & 7.43% will be compensation paid to the Bank]
Interest received on FRA interest rate : $10m x 7.43% = $0.743m
Since the actual interest received by the company is $0.776m but they should be receiving $0.743m, the difference would be what the company has to pay back to the bank of (0.776 – 0.743) = $0.033m
What you have written is correct except for one thing.
All interest rates are always quoted on an annual basis. (The annual rate of interest will be different depending on the length of the borrowing or deposit).
So because in your example, the deposit is for 4 months, all the interest $ amounts that you have calculated should be multiplied by 4/12 so as to arrive at the interest for the 4 months of the deposit.
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