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CA Final · Advanced Financial Management · Interest Rate Risk Management

A bank has sold a 3x6 FRA to a corporate on a notional ₹50 crore at 7.00% p.a. On the settlement date the reference rate is 6.40% p.a. Which statement about the settlement is correct?

The corporate pays the bank. As FRA buyer it locked in 7.00%, but the reference rate fell to 6.40%, so the buyer owes the interest difference on the notional. This is paid discounted at the start of the period, and the notional principal is never exchanged.

  1. AThe bank pays the corporate the interest difference, and the notional principal is exchanged
  2. BThe corporate pays the bank the interest difference, discounted to the start of the period, and the notional principal is not exchangedCorrect
  3. CThe bank pays the corporate the interest difference, discounted to the start of the period
  4. DNo payment arises, since FRA settlement occurs only when the reference rate exceeds the agreed rate

Explanation

The corporate is the FRA buyer and has locked in 7.00%. The reference rate is lower at 6.40%, so the buyer loses and pays the seller (the bank) the difference on the notional, discounted to the start of the period because the settlement is made upfront. The notional principal is never exchanged, which rules out the first option. An FRA settles in both directions, which rules out the last.

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