Question

A company is planning to borrow $120 million after three months for a period of six months. The quote for the loan is LIBOR. The loan rate, LIBOR, will be determined at the start of loan and stay the same for its duration. Currently LIBOR is 3%. The company is willing to pay 3.25% fixed interest on the loan to avoid variable interest.

Part a. Construct a Forward Rate Agreement (FRA) for the company.

Part b. Should the company buy or sell the FRA?

Part c. Show the cash flows at the beginning of the loan for cases if LIBOR equals 2.5%, 3.25%, and 3.75%.

Answer 1

Part a:

12 months - 3 months = 9 months

The company can enter into 3 x 9 Forward Rate Agreement, were the company have to borrow $120 million for the period og 6 months at a rate of 3.25%.

When the LIBOR interest rate increased above 3.25% the company will get the difference & if the interest rate which is below the fixed interest rate that the company will pay that the amount difference.

Part b:
The is afraid of the rise in interest rate, because the company is the borrower. Therefore, the company will buy the Forward Rate Agreement (FRA).

Part c:
LIBOR = 2.5%
Loss to the company = (3.5% - 2.5%) x $120,000,000 x 6/12
= $600,000

Cash flow = ($600,000 / (1+2.5%/2))
= $600,000 / 1.0125
= $592,592.59

LIBOR = 3.25%
Loss to the company = (3.5% - 3.25%) x $120,000,000 x 6/12
= $150,000

Cash flow = ($150,000 / (1+3.25%/2))
= $150,000 / 1.01625
= $147,601.48

LIBOR = 3.75%

Gain to the company = (3.75% - 3.5%) x $120,000,000 x 6/12
= $150,000

Cash inflow = ($150,000 / (1+3.75%/2))
= $150,000 / 1.01875
= $147,239.26