Question

ABC company has a $10 million loan maturing in 3 months that it plans to roll over for a further six months. The company treasurer feels that interest rates will be higher in three months when rolling over the loan. Suppose the current 6-month LIBOR rate is 1.9%.

a) Explain how ABC company can use an FRA at 2% from Banque Paribas to lock in a guaranteed six-month rate when it rolls over its loan in three months (e.g. buy/sell an FRA, underlying principle, what rate will apply and when).

b) In three months, 6-month LIBOR turned out to be 1.75%. How much will ABC company receive/pay on its FRA?

Answer 1

a) Using FRA:

Since, ABC company wants to roll over the loan and is scared of interest rate rising, it should buy FRA as FRA buyer is scared of interest rate rising while FRA seller is scared of interest rate falling. FRA would look like as follows:

3v9 $10 Million FRA @2%

Here, 3v9 explains the life of FRA contract. 9 explains the total life of FRA contract i.e. 9 months from now. It is of exchanging the cashflows at 6 month LIBOR which is after 3 months from now. So, after 3 months whatever will be the prevailing 6 months LIBOR that would become the floating leg of this FRA contract.

$10 Million represent the Notional Principal on which the payoff would be calculated.

2% is the fixed leg of exchange while floating leg of interest rate would be benchmark i.e. LIBOR in this case.

Now in case of this FRA, we have agreed to accept the floating leg i.e. LIBOR and pay the fixed leg of 2%. In case, interest rate is below than 2%, we would have to pay the difference on FRA but we can roll over the loan at cheap interest rate. In net, we would roll over at 2%. Even in case of rise, we would receive difference on FRA while we would roll over at high interest rate which would be comepnsated by FRA reciept. Thus, overall in any case our net rollover would be at 2% only.

(b) FRA Payoff Calculation:

6 Months LIBOR = 1.75%

Fixed leg of FRA = 2%

Notional Principal = $10 Million

Payoff on FRA =

Payoff on FRA =

Payoff on FRA = - $12,392.04

ABC should pay $12,392.04 for his FRA contract settlement.