Question

fosmay limited is a wholly owned Ghanaian company that manufactures roofing sheets. The company exports to a number of west african coutries including Ngeria, Togo and Benin. As a result of an increase in both local and international demand for its products, the company has decided to expand its production facilities at en estimated cost of GH¢51 milion . The company intends to borrow this amount in three months time to for a term of six months . The previaling inerest rates is 28.5% but the company expect this to rise to about 35.5% in three months time.

Unibank Ghana Limited the bankers of the Fosmay Limited is guarateeing an interest rate of 30.5% in three months for a period of six months. The company has therefore decided to enter into a Forward Rate Agreement with Unibankn Ghana Limited and all the necessary agreements have been signed by both parties.

Required:

a) What is forward rate agreement and why has Fosmay Limited signed this agreement

b) Expalin what will ahppen if interest rates rise to 35.5% in three months

c) Explain what will happen if interest rate fall to 26.5% in three months

d) Outline two merits and demerits of using a forward rare agreement

Answer 1

a)

A Forward Rate Agreement, or FRA, is an agreement between two parties who want to protect themselves against future movements in interest rates. By entering into an FRA, the parties lock in an interest rate for a stated period of time starting on a future settlement date, based on a specified notional principal amount. The buyer of the FRA enters into the contract to protect itself from a future increase in interest rates. This occurs when a company believes that interest rates may rise and wants to fix its borrowing cost today. The seller of the FRA wants to protect itself from a future decline in interest rates. This strategy is used by investors who want to hedge the return obtained on a future deposit.

Fosmay Limited has signed this agreement to hedge the risk associated with increase in interest rate with the other party who wants to hedge the risk against decline in interest rate.

b)

If interest rates increases to 35.5% as expected by Fosmay and if it entered into Foward Rate Agreement with Unibank Ghana than Fosmay has to pay only 30.5% on borrowed amount i.e.

Borrowed amount = GH 51 Million

Interest amount with hedge = 51 * 30.5 /2 = GH 7.7775 Million

Interest amount without hedge = 51 * 35.5 /2 = GH 9.0525 Million

So the total interest amount has been decreased by = GH 1.275 Million

c)

If interest rates decreases to 26.5% as not expected by Fosmay and if it entered into Foward Rate Agreement with Unibank Ghana than Fosmay has to pay as per 30.5% on borrowed amount i.e.

Borrowed amount = GH 51 Million

Interest amount with hedge = 51 * 30.5 /2 = GH 7.7775 Million

Interest amount without hedge = 51 * 26.5 /2 = GH 6.7575 Million

So the total interest amount has been increased by = GH 1.02Million

d)

Advantages:-

- Protection against interest rate fluctuation:-

As we have seen in above example that FRA can be used for hedging against interest rate fluctuation.

- FRAs do not have to be arranged from the provider of the original loan.

FRA can be arranged with anyone that does not need to be bank. Counterparty could be anyone i.e. individual, investor etc.

Disadvantages:-

- Credit of Counterparty:-

The downside to FRAs being is the fact that you need to consider the credit of your counterparty. At the time of making the agreement, you don’t know whether you will be receiving the payment at settlement date or counterparty refuses to fullfill the agreement. Because no clearing house is involved in the agreement, you rely on the credit of the counterparty.

- FRAs are often only available for large amounts – for example, notional principals above £500,000

Thank You!!