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Dear Sir Moffat,
I have some questions regarding to this long technical article,
Q1. the comment under the answer for the FRA mentioned,
“ the 2 calculations should give the same effective annual interest rate”same goes to the comment under the answer for the options,
“ If one of the options is exercised for both interest rates, as the 94.25 is here, the calculations should give the same result. “why is that so? even though there are an increase of 1.1% and decrease of 0.6% in internest rate? why the EIR are the same?
Q2. Under the Discussion heading
“If Wardegul Co feels there is a possibility that interest rates will be higher than 5.41%, the point at which the 94.25 option would not be exercised, it may choose this option rather than the future. “
i couldn’t find where is the 5.41% come from, i have tried to search the article but there is no future price of 94.59.
Q3. Are all of the Over-the-counter(OTC) instruments (Forwards, interest rate guarantee and money market hedge) having counter party risk because the bank may default on the agreement due to economic uncertainty?
Thank you!
FRA’s will always end up with the same effective interest rate because that is the purpose of an FRA. The bank is fixing the rate at 5.02% and so if the actual interest rate is higher then we pay the extra to the bank but if the actual interest rate is lower then the bank pays us the difference.
Options are fixing a minimum interest rate here (since we are investing money). Choosing an exercise price of 94.25 is effectively fixing the minimum interest at 5.75% (less the premium payable and the basis risk). If the option is exercised (because there is a gain if exercised and we will exercise if the actual interest rates are too low) then automatically there will be the same effective rate.
For the option not to be exercised, the future price will have to be less than 94.25. The equivalent interest rate will be 100 – 94.25 – 0.34 (the basis) = 5.41%
All OTC instruments have counterparty risk for the reason you state.
I do suggest that you watch my free lectures on the management of interest rate risk.
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