Question

1. Ford has a $20 million Eurodollar deposit maturing in two months that it plans to roll over for a further six months. The company's treasurer feels that interest rates will be lower in two months’ time when rolling over the deposit. Suppose the current LIBOR 6 month rate is 7.875%.

a. Explain how Ford can use an forward rate agreement (FRA) at 7.65% from Banque Paribas to lock in a guaranteed six-month deposit rate when it rolls over its deposit in two months.

b. After two months, LIBOR 6 month rate has fallen to 7.5%. How much will Ford receive/pay on its FRA? What will be Ford's hedged deposit rate for the next six-month period?

c. In two months, the LIBOR 6 month rate has risen to 8%. How much will Ford receive/pay on its FRA? What will be Ford's hedged deposit rate for the next six months?

Answer 1

Ford can use forward rate agreement (FRA) at 7.65% to lock in six month deposit rate rate while rolling over deposit in two months.

A forward rate agreement (FRA) is a cash-settled OTC contract between two counterparties, where the buyer is borrowing (and the seller is lending) a notional sum at a fixed interest rate (the FRA rate) and for a specified period of time starting at an agreed date in the future.

Ford can enter into swapping agreement at LIBOR and additionally can enter into a FRA at fixed rate of 7.65%.

As a result Ford will pay interest on deposit at current LIBOR and will pay / receive interest under FRA making actual payment of interest along with FRA and deposit at 7.65% irrespective of the actual rate of LIBOR%

b. if ford had made FRA at the rate of 7.65% and LIBOR has fallen to 7.5%, then ford will pay 7.5% on deposit and 0.15% on FRA making total payment of interest at 7.65% on its deposit after hedging.

C. if LIBOR has risen to 8% then Ford will pay 8% on deposit and will receive 0.35% under FRA, which will work out as payment of total 7.65% for the deposit after hedging.