Question

You take a 1 million 9-month Eurodollar deposit to finance a 1 million 6-month Eurodollar loan. You are worried about interest rate risk and you would like to use a FRA contract to hedge your risk exposure. The appropriate FRA contract you should consider is: Select one: a. Sell a 6 against 9 FRA on a notional amount of $1 million b. Buy a 3 against 6 FRA on a notional amount of $1 million c. Sell a 3 against 6 FRA on a notional amount of $1 million d. Buy a 6 against 9 FRA on a notional amount of $1 million

Answer 1

The correct option is "D". "Buy a 6 against 9 FRA on a notional amount of $1 million." The reason being, since we have borrowed for 9 month and financed a 6 month loan, we are covered for 6 months but exposed to interest rate risk for 3 months after 6 months from today. And a 6 against 9 FRA will protect for a 3 month borrowing commitment starting 6 months from today. And the reason for buying it instead of selling the same is that we have borrowed (or we are afraid of rates going up), so we have to buy a FRA agreement. Hence the correct option is d.

The other options are incorrect because:

"Option a" talks about selling a 6 against 9 FRA but we have to buy instead of selling it, so it is incorrect.

"Option b" and "Option c" talks about 3 against 6 FRA which means it will protect a borrower or lender for 3 months borrowing/lending commitment starting 3 months from today. So both the options are incorrect because we need protection for 3 months starting 6 months from today.