AFMFRA

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

Why did they times the difference n by 1/(1+(3.5%*4/12))