FRA

Question

Assume that it is now 1 June. Your company expects to receive £7.1 million from a large
order in five months’ time. This will then be invested in high-quality commercial paper for a
period of four months, after that it will be used to pay part of the company’s dividend. The
company’s treasurer wishes to protect the short-term investment from adverse movements
in interest rates, by using futures or forward rate agreements (FRAs).
The current yield on high-quality commercial paper is LIBOR + 0.60%.
LIFFE £500,000 three month sterling futures. £12.50 tick size.
September 96.25
December 96.60
Futures contracts mature at the month end. LIBOR is currently 4%.
FRA prices (%)
4 v 5 3.85 – 3.80
4 v 9 3.58 – 3.53
5 v 9 3.50 – 3.45

Answer
FRA:
The FRA fixed rate is 3.45%. Actual LIBOR is 3.5%. The company will therefore have to
make a payment to the bank.

This will be: £7.1m (3.50% – 3.45%) × 4/12 ×1/ (3.5% 4 /12)

or £1,169.65

I am not understanding the solution I just did this: £7.1m (3.50% – 3.45%) × 4/12= 1183