Question

You’re a bank having made a loan of $250 million. The borrower pays 3-month LIBOR + 1.5%. The loan began two months ago, so the next re-pricing (interest rate setting) date is in one month. What is your risk, and how could you hedge?

a) Your risk is that LIBOR will increase within a month; you can hedge by entering into a 1x4 FRA as a “lender” of $250 million.

b) Your risk is that LIBOR will increase within a month; you can hedge by entering into a 3x6 FRA as a “lender” of $250 million.

c) Your risk is that LIBOR will decrease within a month; you can hedge by entering into a 1x4 FRA as a “lender” of $250 million.

d) Your risk is that LIBOR will decrease within a month; you can hedge by entering into a 3x6 FRA as a “borrower” of $250 million.

e) Your risk is that LIBOR will increase within a month; you can hedge by entering into a 3x6 FRA as a “borrower” of $250 million.

Answer 1

Option C is correct.

c) Your risk is that LIBOR will decrease within a month; you can hedge by entering into a 1x4 FRA as a “lender” of $250 million.

Lender of FRA receives fixed rate and pays floating rate.

As I have given loan of $250million at LIBOR + 1.5%, I am expecting to receive floating rate. To hedge receving floating rate, I have to enter a FRA contract as a lender.

Also, 2 months have already passed so I will enter a FRA of 1x4 that is 3months loan beginning in 1month.