Question

Mary Hames took a short position in a FRA with a notional principal of $10,000,000. The agreement expires in 30 days and is based on a 90-day LIBOR. The FRA is based on a fixed rate of 6%. Assume that at expiration, the 60-day LIBOR is 5.25%, and the 90-day LIBOR is 5.5%.

• Calculate the value of the FRA at expiration. Is Mary Hames to receive or to pay money?

• What may have motivated Mary Hames to enter into the FRA? Be as specific as you can.

Answer 1

Hi,

Rules:

• If the actual/reference rate < FRA/agreement rate with buyer = Buyer pays seller, the value of the FRA
• If the actual/reference rate > FRA/agreement rate with buyer = Seller pays buyer, the value of the FRA

Calculations:

Value of the FRA = Settement amount * Discount factor

=$10,000,000 [(0.055 - 0.06)*90/360] / [1+ 0.055(90/360)]

= $10,000,000 [-0.00125/1.01375]

=- $12330.45

Hence as per the rule if the actual/reference rate < FRA/agreement rate with buyer = Buyer pays seller, the value of the FRA, Mary homes will receive $12,330.45

What may have motivated Mary Hames to enter into the FRA?

FRA are OTC contracts and are very flexible and the exposure for the seller is only the Settlement amount, rather than the entire principal amount.

Even if something happens and the interest rates moves against the seller, still the contract can be Netted using a reverse agreement in the opposite direction, in short ease of exit.

Mary wants a fixed lending rate so that she will be protected against a fall in the interest rates, on the other hand buyer who locks in the borrowing rate will be protected against rise in the rates.

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