Question

Wells Fargo believes that LIBOR rates will increase, and Bank of America believes LIBOR rates will decrease. Which bank should buy and sell an FRA?

They set an agreement rate at 3.3% for three-month LIBOR. The settlement date will occur in seven months. The notional amount is $35,000,000. Assume every month has 30 days. If the settlement rate ends up at 4.5%, what has the winner earned (remember an FRA is settled not at the end of the contract period of the FRA, but when the settlement rate is determined)?

Answer 1

Fargo believes that interest rate will increase, so it will want Fixed interest rate so that increase in interest rate does not effect it. So it should buy FRA

Bank of America think that interest rate will decrease, so it will be willing to take benefit of decrease in interest rate, so it should sell FRA

Agreement rate i.e. FRA rate = 3.30% for 3 month LIBOR

it means, in any case, Fargo will pay Fixed interest rate for 3 months and receive LIBOR for 3 months from Bank of America

Total Days in period = 30*3 = 90

Total days in year= 360

On settlement date, interest rate = 4.50%

For fargo

Interest rate paid by Fargo = -3.30%

LIBOR received by Fargo = 4.50%

net received = 1.20%

Notional amount = 35000000

net Amount received by Fargo = Net rate *Notional amount*days/360

35000000*1.2%*90/360

$105000

For Bank of America

Interest rate received fixed = 3.30%

LIBOR paid = -4.50%

net paid interest rate = -1.20%

Notional amount = 35000000

net Amount paid by bank of America = Net rate *Notional amount*days/360

35000000*-1.2%*90/360

-105000

So, net amount received by Fargo from Bank of America is $105,000. Fargo is winner earned